‘Reducing Systematic Risk with an International Financial Code’ A Thesis submitted by Hassaan Joosub in partial completion of the award of Doctor of Philosophy
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Geneva School of Diplomacy and International Relations University Institute 2018
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JOOSUB 3 Geneva School of Diplomacy and International Relations University Institute
Name: Hassaan JOOSUB
Title: ‘Reducing Systematic Risk with an International Financial Code’
Advisor: Osvaldo R. AGATIELLO
Abstract
This paper suggests an alternative framework for money, banking and finance. Aspects and applications of Abrahamic law are explored along with other banking reform plans, namely the Chicago Plan, the IMF’s Special Drawing Rights, and the gold standard. The epilogue also takes a special look at the applications of the evolving blockchain technology phenomenon. Historical real economy transactions demonstrate the transformation of gold, silver and other asset backed currencies as a means of exchange, to bills, representing a fiat currency. Existing government, corporate and banking structures prove that the aforementioned transformation has facilitated disequilibrium in the global monetary system by relying on the tenets of interest, debt and speculation. Nine areas of systematic financial importance have been isolated for examination and structural reform. Thus, the aftermath of the Bretton Woods system reveals the duality of apparently flourishing commerce coupled with a degradation of ethics in international finance. The polarity on wealth and lifestyle has never been so wide. Existing research on historical policies and various banking products exhibits the inescapable cyclical nature of the global financial economy. Many reputable scholars agree that our financial ecosystem is on the brink of catastrophic collapse. This paper will explore and recommend alternative principles for immediate adoption that may aid in avoiding a global economic catastrophe. Historical evidence referenced in the body of the paper will justify the macroprudential reform proposals that ultimately culminate into an International Financial Code. This series of nine Articles detail the proposed fully backed, bimetallic Special Drawing Right, which proves to remain secular whilst being more ethical in approach.
Word Count: 71,000 JOOSUB 4 TABLE OF CONTENTS
GLOSSARY 7
PROLOGUE 11
INTRODUCTION 16
LITERATURE REVIEW 24
1. CHAPTER 1 – HISTORICAL CONTEXT 24 1.1. Circa 1640, Modern Banking is Born 24 1.2. 1880 to the Great Depression, The Golden Years of the Gold Standard 26 1.3. 1944 to 1971, The Bretton Woods Agreement 28 1.4. 1971 to Today, The Aftermath of the Bretton Woods Agreement 32
2. CHAPTER 2 – MINOR REFORMS 34 2.1. Dodd-Frank Act, 2010 34 2.2. Central Banks and Other Regulatory Bodies 37 2.3. Ethical Attempts – Economic Policy Prescriptions 40 2.4. Ethical Attempts – Islamic Finance? 42
3. CHAPTER 3 – MAJOR REFORMS 57 3.1. Solutions with a Short Shelf Life 57 3.2. The Chicago Plan 59 3.3. Special Drawing Rights 62 3.4. The Gold Standard 66
4. CHAPTER 4 – REGULATORY PERSPECTIVES 74 4.1. Structural Versus Cyclical 74 4.2. Macroprudential Versus Microprudential 78
METHODOLOGY 84
5. CHAPTER 5 – RESEACH APPROACH 84 5.1. Selection Criterion 84
RESEARCH ANALYSIS 88
6. CHAPTER 6 – EXAMINATION OF CURRENT LANDSCAPE 88 6.1. Money 88 6.2. Debt 93 6.3. Capital Adequacy 97 6.4. Credit Rating Agencies (CRA) 103 6.5. Accounting Principles 106 6.6. Shadow Banking 109 6.7. Derivatives 111 6.8. Too big to Bail – too big to fail 115 6.9. Proprietary Trading 120
JOOSUB 5 IMPLICATIONS OF RESEARCH FINDINGS 125
7. CHAPTER 7 – REVISION OF MINOR REFORMS 125 7.1. ‘Ethical’ Finance Revisited 125 7.2. Platform for Ethical Codification 128 7.3. International Financial Code 131
8. CHAPTER 8 – REVISION OF MAJOR REFORMS 148 8.1. A ‘Gold Standard’ Revisited 148 8.2. Monetarists Versus Austrians 152 8.3. The Golden SDR 156 8.4. The Silver Crutch 158
9. CHAPTER 9 – INTERNATIONAL FINANCIAL CODE 167 9.1. Connection to Research Analysis 167 1. Article I 168 2. Article II 172 3. Article III 173 4. Article IV 175 5. Article V 177 6. Article VI 178 7. Article VII 181 8. Article VIII 182 9. Article IX 184
10. CHAPTER 10 – FUTURE LANDSCAPE 187 10.1. The Faustian Prospect 187 10.2. What is the Role of Banks? 191 10.3. The End is Nigh 194 10.4. IMF in the Spotlight 199
CONCLUSION 207
11. CHAPTER 11 – RESEARCH FINDINGS 207 11.1. Existing Contributions 207 11.2. Original Contributions 208 11.3. Research Limitations 212 11.4. Implications for Future Research 216 11.5. Closing Remarks 220
EPILOGUE 222
12.1. An Ode to Blockchain 222 12.2. Decentralization Revolution 223 12.3. The End of Cash 226 12.4. Blockchain Decoded 227 12.5. The Useful Puzzle 229 12.6. Absolute Transparency 230 12.7. Mining 232 12.8. The Birth of Bitcoins 233 12.9. Bitcoin Mania 237 13.0. Funny Money 241 JOOSUB 6 13.1. New Frontiers 245 13.2. Déjà Vu 248 13.3. Theoretical Justifications 250 13.4. In Defence of Easy Money 256 13.5. Seven Habits of a Highly Effective Bitcoin 263 13.6. Geopolitical Tension 267 13.7. Connection to Research 271 13.8. Bitcoin Teething Troubles 275 13.9. David and Goliath 280 14.0. Conclusions 287
REFERENCE LIST 294
• Books 294 • Books with an Editor 295 • Journals 295 • Newspapers, Print & Digital 296 • Websites 300 • Blogs 308 • Interviews 309 • Government Agency Publications 309 • Parliamentary & Legal 311 • Conferences 311 • Theses & Studies 311 • Audio Visual 315
JOOSUB 7 GLOSSARY
AAOIFO Accounting and Auditing Organization for Islamic Financial Institutions ABCP Asset Backed Commercial Paper Conduit ABCT Austrian Business Cycle Theory ACE Allowance for Corporate Equity AI Artificial Intelligence AIIB Asian Infrastructure Investment Bank ASIC Application Specific Integrated Circuit ATM Automated Teller Machine AUM Assets Under Management BCBS Basel Committee on Banking Supervision BCCI Bank of Credit and Commerce International BIS Bank of International Settlements BLME Bank of London and The Middle East BRICS Brazil, Russia, India, China, South Africa BTC Bitcoin BWC Bretton Woods Committee CAR Capital Adequacy Ratio CBCC Central Bank Cryptocurrency CBOE Chicago Board Options Exchange CD Certificate of Deposit CDO Collateralized Default Obligation CDS Credit Default Swap CDX Credit Default Swap Index CEO Chief Executive Officer CET1 Common Equity Tier 1 CFR Council on Foreign Relations CFTC Commodity Futures Trading Commission CIA Central Intelligence Agency CME Chicago Mercantile Exchange COMMEX Commodity Exchange, Inc. CPI Corruption Perceptions Index CPU Central Processing Unit CRA Credit Rating Agency CRIF Credit Information S.p.A CRM Customer Relationship Management DBRS Dominion Bond Rating Service Limited DIB The Dubai Islamic Bank DIF Deposit Insurance Fund DLT Distributed Ledger Technology DoD Department of Defence, U.S. ECDSA Elliptical Curve Digital Signature EMDC Emerging Markets and Developing Economies EMH Efficient Market Hypothesis EMIR European Market Infrastructure Regulation ESMA European Securities and Market Authority ETF Exchange Traded Fund EU European Union FASB Financial Accounting Stability Board FASEB Federation of American Societies for Experimental Biology FINMA Swiss Financial Market Supervisor Authority JOOSUB 8
FOMO Fear of Missing Out FSA Financial Services Authority, UK FSB Financial Stability Board FT Financial Times FX Foreign Exchange G10 Group of Ten G20 Group of Twenty G30 Group of Thirty GAAP Generally Accepted Accounting Principles GBP British Pound (ISO 4217) GDP Gross Domestic Product GE General Electric GFSN Global Financial Safety Net GPI Global Peace Index GLBA Gram-Leach-Bliley Act, 1999 GM General Motors HBS Harvard Business School HDI Human Development Index HPM High Powered Money HQLA High Quality Liquid Assets HSBC Hong-Kong Shanghai Banking Corporation IAIS International Association of Insurance Supervisors IAS International Accounting Standards IASB International Accounting Standards Board IBRD International Bank for Reconstruction and Development ICAAP Internal Capital Adequacy Assessment Process ICO Initial Coin Offering ICU International Clearing Union IDB Islamic Development Bank IEF Index of Economic Freedom IFC International Financial Code IMF International Monetary Fund ING International Netherlands Group IOSCO International Organization of Securities Commission IPO Initial Public Offering ISDA International Swaps and Derivatives Association ISO International Standardization Organization KKK Ku Klux Klan KYC Know Your Customer LCR Liquidity Coverage Ratio LIBOR London Interbank Offered Rate LSE London School of Economics M0 Narrow Money, base money M1 Near Money, M0 + savings and timed deposits M2 M0 + M1 + larger corporate assets MIT Massachusetts Institute of Technology MMMF Money Market Mutual Fund NDB New Development Bank NFC Non-Financial-Counterparty NOW Negotiable Order of Withdrawal JOOSUB 9
NRSRO Nationally Recognized Statistical Rating Organization NSA National Security Agency OCA Optimal Currency Area OCC Office of the Controller of the Currency, U.S. OECD Organization for Economic Co-operation and Development OIC Organization of Islamic Cooperation OMO Open Market Operations OTC Over-the-Counter OZ Ounce (28.34g) OZ T Troy Ounce (31.1g) P2P Peer-to-Peer PBOC People’s Bank of China PBUH Peace be Upon Him PIMCO Pacific Investment Management Company PLS Profit and Loss Sharing POW Proof-of-Work PRA Prudential Regulation Authority, United Kingdom QE Quantitative Easing RAA Reserve Asset Account RBS Royal Bank of Scotland RMB Chinese Yuan (ISO 4217) RWA Risk Weighted Assets SBC Senate Banking Committee, U.S. Congress SDR Special Drawing Right SEC Securities and Exchange Commission, U.S. SegWit Segregated Witness SGE Shanghai Gold Exchange SIFMA Securities Industry and Financial Markets Association SILA Saving Investment and Loan Account SIV Structured Investment Vehicle SME Small to Medium Enterprise SNB Swiss National Bank TARP Troubled Asset Relief Program, U.S. TCP/IP Transmission Control Protocol Over Internet Protocol TWh Terawatt Hours U.S. United States of America UBS Union Bank of Switzerland UK United Kingdom UN United Nations USD United States Dollar (ISO 4217) VAR Value at Risk WB World Bank WGC World Gold Council WMD Weapon of Mass Destruction WWI World War I WWII World War II XDR Special Drawing Right (ISO 4217) JOOSUB 10 JOOSUB 11
PROLOGUE
Banking cannot be spoken of without an inference to money; it is therefore imperative that a clear understanding of the constitution of money is established, something too often overlooked.
As far back as the 11th century, renowned Persian jurist and philosopher Al-
Ghazzali is noted for saying:1
…It becomes easy for the financier to earn more money on the basis of interest
without bothering himself to take pains in real economic activities. This leads to
the hampering of the real interest of humanity, because the interests of humanity
cannot be safeguarded without real trade skills, industry and construction… And
whoever effects the transactions of interest on money is, in fact, committing
injustice, because money is created for some other things, not for itself. So, the
one who has started trading in money itself has made it an objective contrary to
the original wisdom behind its creation, because it is injustice to use money for a
purpose other than it was created for…
Whilst some might disagree, the medieval concept of usury, defined by the Fifth
Lateran Council (1512-1517), is in fact only a stone’s throw away from the modern concept of interest bearing debt:2
1 Abū Ḥāmid Muḥammad ibn Muḥammad al-Ghazālī (1058 –1111), Excerpt cited by Justice Muhammed Taqi Usmani, “The Adverse Effects of Interest on Society,” Institute of Islamic Banking and Insurance, (2009): accessed 2 July 2015, http://www.islamic-banking.com/iarticles_9.aspx.
2 Pope Leo X, “Fifth Lateran Council 1512-16 A.D.” Papal Encyclicals Online. (1515): Session 10, accessed 3 July 2015, http://www.papalencyclicals.net/Councils/ecum18.htm. JOOSUB 12
… According to Luke the Evangelist, [The Lord] has bound us by a clear
command that we ought not to expect any addition to the capital sum when we
grant a loan. For that is the real meaning of usury: when, from its use, a thing
which produces nothing is applied to the acquiring of gain and profit without
any work, any expense or any risk.
The repetitive sentiment seems to show concern over speculation and the charging of interest in the exchange of money, added to the far-reaching societal and economic consequences of such practices. Yet these sermons from the throngs of history may seem draconian to the present-day banker, when in fact evidence points to their timelessness. Moreover, they have been echoed from secular intellectuals the world over.
If we go yet deeper into western history, around 350 BC, in his Politics,
Aristotle explains that:3
The most hated sort [of wealth getting] and with the greatest reason, is usury,
which makes a gain out of money itself and not from the natural object of it. For
money was intended to be used in exchange but not to increase at interest. And
this term interest, τόκος, which means the birth of money from money is applied
to the breeding of money because the offspring resembles the parent. Wherefore
of all modes of getting wealth, this is the most unnatural.
3 Aristotle, Politics (England: Penguin Books, 1981, Book 1). JOOSUB 13
Money has no intrinsic value and Aristotle is emphasizing that its primary objective was to serve society as a means of exchange. All transactions must be attached to the real economy, or else money becomes commoditized.
Despite referencing the views of some brilliant minds, interest still thrives. Its birth cannot have been without reason or benefit. Some scholars posit that the origins of interest bearing loans were in fact based on agricultural products. Our earliest knowledge of such products was exhibited shortly after the great plough revolution of
4000 BC. Loans were amongst farmers and in the form of grain, tools and animals. One seed could generate a hundred more; hence repayment with ‘interest’ in additional seeds was easy and logical. Tools had the power of creation, thus interest in the form of what was created could be shared. Finally, when animals were loaned, interest was paid in the form of newborns (the Sumerians used the word ‘mas’ for both calves and interest).
What was loaned had usufruct ends in and of itself as well as the natural power of generation.4
Interestingly, when for the first-time society did taste interest, propagated by
‘Divine’ authorities of the Ancient Oriental System (Egypt, Assyria and Sumeria), the economy suffered from disequilibrium. Interest was paid on loans in metals, in the form of more metals. Although, socially this was viewed as odd, since metals are inorganic and to pay the interest on that type of loan another process would need to be introduced.
Farmers were not able to repay a loan exceeding what they could harvest and were sometimes forced into slavery as a result; moreover, prices of a respective harvest were never guaranteed since they fluctuated depending on aggregate yield. A response to this
4 Stephen Zarlenga, “A Brief History of Interest (Copyright 2000),” Research & Articles by American Monetary Institute, 18 December 2010, http://www.monetary.org/a-brief-history-of-interest/2010/12.
JOOSUB 14 dilemma came in the form of the Babylonian Code of Hammurabi,5 circa 2000 BC. Had this law not limited usury to a nonetheless extortionary 33 percent, farming, as an industry, may have been synonymous with slavery.6 The Torah heralded a timely message when one of its miscellaneous laws stipulated that:7
You shall not charge interest on loans to your brother, interest on money,
interest on food, interest on anything that is lent for interest.
Such laws were manifold. The Hindu law of ‘Damdupat’ put several restrictions on interest. Emperor Justinian’s 6th century Byzantine code reduced interest to nearly 4 percent. Charlemagne flatly forbade interest in 9th Century’s Western Europe. The
Magna Carta Libertatum placed stern limits on usury in 13th century England. In fact, most states in the United States had federal limits on usury until 1981. The Bible and
Quran too are not alone in their prohibition of interest.8
The short history of Homo sapiens has seen the development of wondrous and advanced civilizations. Our current modern history exemplifies social evolution.
Examples include the abolishment of slavery, the empowerment of women and equal voting rights for all. Yet the topics of interest, money and debt were only historically debated in a theological and philosophical sense, such were the bygone days in which higher truths were relentlessly pursued. The secular veil of post-Enlightenment history
5 John D. Prince, “The Code of Hammurabi.” The American Journal of Theology, Volume 8, No. 3 (1904): pp. 601-609, The University of Chicago Press, accessed 5 July 2015, http://www.jstor.org/stable/3153895.
6 Zarlenga, (2000), op. cit.
7 The Torah, Deuteronomy 23:19, 7 BC.
8 Zarlenga, (2000), op. cit.
JOOSUB 15 has proved its boon by bringing with it innumerable social advances. That being said, mounting government, sovereign and household debts signal that a system believed to be working well for all in improving economic and social circumstances is starting to reveal weaknesses.9 In humility, it can therefore only submit its many premises, more recently and frequently challenged, to the timeless arm of reason and evolution.
9 Richard Dobbs et al, “Debt and (not much) deleveraging,” McKinsey & Company, (2015): Exhibit 1, accessed 5 July 2015, http://www.mckinsey.com/insights/economic_studies/debt_and_not_much_deleveraging. JOOSUB 16
INTRODUCTION
“Money drills what the drill cannot drill.”
- Unknown
We are at the mercy of a cyclical financial system, the concerns of which are structural. It goes through periods of growth and prosperity and then decline, usually taking the economy with it. There is no evidence in the annals of history of a utopian financial system free of flaws and systematic risk. Unpredictable factors can trigger crises at any time: speculation or bubbles, wars, policy decisions, government intervention or lack thereof and much more.10 As we climb out of one cataclysm we seem to set ourselves on a trajectory for the next. The existing literature covering the various topics of currencies, early financial systems and modern economies is copious.
Each topic alone is a respected body of thought.
According to a journal entry in the International Monetary Fund’s (IMF)
Finance and Development, there are broadly speaking, two types of reform policies, stabilization and structural.11 The former deals with demand management and the latter deals with the fabric of the economy. This paper will aim to present evidence that recent financial stabilization policies, such as Quantitative Easing (QE), have been faint remedies to financial instability because the International Monetary System (IMS) requires changes to the over-arching economic structure.
10 Alrifai, Tariq, Islamic Finance and the New Financial System (Singapore: Wiley, 2015), 7.
11 Khaled Abdel-Kader, “What are Structural Policies?” Finance and Development Volume 50, No. 1 (2013): accessed 8 February 2016, http://www.imf.org/external/pubs/ft/fandd/2013/03/basics.htm. JOOSUB 17
The lack of structural reforms has contributed to financial instability, fraud, insider trading and other criminal activities, which are also fast gaining scrutiny in a literature body of their own. They have instigated increasingly severe financial crises, on average every three years.12 Coupled with a wave of financial disintermediation since the late 1970’s, financial institutions have faced unprecedented competitive pressures. Trust has been shaken and financial institutions they have foregone their role as market authorities; they are now market players, on the hunt for yield. This has forced banks into a synchronic approach (short-term, high financial innovation/engineering) to their activities as opposed to a diachronic approach (long- term, investment in productive assets, job creation).13 This is of particular concern for this research because the traditional banking practice of borrowing short, in the form of demand deposits and lending long cannot sustain itself in the face of increasing competitive pressures brought on by capital markets and the advent of shadow banking.14 One of the many follies that contributed to the demise of Lehman Brothers was using short-term liabilities to invest in illiquid, long-term (toxic) assets.15
Borrowing short and lending long is an obvious maturity mismatch, succeeding in that industry meant effective management of that mismatch.
However, this paper will suggest that a financial institution’s fiduciary duty to its clients is no longer a bank’s primary prerogative. We must understand the demands
12 Alrifai, (2015), 49, op. cit.
13 Lena Rethel and Timothy J. Sinclair, The Problem With Banks (London: Zed Books, 2012), 3.
14 Rethel, (2012), 2, op. cit.
15 Christopher Haress, Kathleen Calderwood, “The Death Of Lehman Brothers: What Went Wrong, Who Paid The Price And Who Remained Unscathed Through The Eyes Of Former Vice-President,” International Business Times, 13 September 2013, accessed 3 November 2015, http://www.ibtimes.com/death-lehman-brothers-what-went-wrong-who-paid-price-who- remained-unscathed-through-eyes-former-vice.
JOOSUB 18 of institutions in this industry if we were to make sense of their actions. We must understand the severe lack of a framework that is conducive to ethical and productive financial conduct. We cannot underestimate how meandering government policy has shaped the behaviour of banks. Yet we cannot make sense of government policy decisions unless we observe the historical context in which they originated and evolved.
There are several excellent general reviews on financial reform from governments, institutions and academics, although each to some extent focuses only on problems at home, or references only the authors own opinions. The increasing volatility of our “financialized economy” and the urgent need for transformation has resulted in a pace of development and breadth of research that is truly staggering.
Therefore, a truly comprehensive review is probably impossible; it is furthermore beyond the scope of this thesis. The following focused review commences by presenting a concise historical account of pivotal dates in the modern history of our financial economy.
The current body of financial literature has seen contributions from all corners of the world. This paper has however, selectively referenced not only popular contributions by history’s most experienced and influential authorities, but it has also gone further by selecting often overlooked material from understated, yet insightful figures. That fact alone makes it a unique synthesis, putting forward the best available information from the most credible and diverse sources. A few of the references include
Paul Volcker, former Chairman of the Federal Reserve and chairman emeritus of the
Group of 30 (G30); Joseph Stiglitz, Nobel Prize Laureate in economics 2001; Harris
Irfan, former Deutsche Bank investment banker; and Justice Taqi Usmani, one of the foremost scholars in Islamic finance. JOOSUB 19
These experts have painted a remarkably detailed and thought provoking context for reform. That being said, these dynamic ideas are only a reflection of their authors’ respective professional expertise. For example, in one of his latest reports, Paul Volcker talks specifically about consolidating financial regulatory bodies within the United
States.16 He makes brilliant suggestions, based on his experience as former chairman of the Federal Reserve System as to how his approach will tackle the rapid rise of shadow banking activities, yet he would not necessarily venture into the territory concerning actual over-the-counter banking products/derivatives. On the other hand, Justice Mufti
Taqi Usmani argues philosophically and pragmatically about the adverse effects of interest on society, inflation and resource allocation.17 All the while his insights are yet to be conceptualized in conjunction with modern proposals on banking reform.
Therefore, despite the fact that great strides have been made in recent years in the field of financial and banking reform, there remains to be seen a piece of work that consolidates and presents specific proposals in a cogent and tangible manner.
This paper will not evaluate and propose an idyllic one-size-fits-all solution to our wildly fluctuating world of finance. The literature review will not attempt to chronologically walk through the financial developments of the past millennium either, many of which have significantly shaped our current predicaments. Yet since the ultimate objective of this paper is to be remedial in nature, it can be seen that the consistent theme throughout the literature reviewed is that of past, present and future financial reform attempts. Thus, Chapter one will start by only focusing on four pivotal dates: 1640, when the Royal Mint ceased to house private and public wealth; 1880,
16 Paul Volcker, “Reshaping the Financial Regulatory System – Long Awaited, Now Crucial,” Volcker Alliance, 20 April 2015, https://volckeralliance.org/resources/reshaping-financial-regulatory- system.
17 Justice Mufti Taqi Usmani, “The Adverse Effects of Interest on Society,” Institute of Islamic Banking and Insurance, http://www.islamic-banking.com/iarticles_9.aspx. JOOSUB 20 which was the zenith of the global gold standard: 1944, with the creation of the Bretton
Woods System (formerly known as the United Nations Monetary and Financial
Conference); and 1971, when the Vietnam War expenditure gave way to the end of the
Bretton Woods system and the birth of the existing fiat regime.
Chapter two will evaluate what would be considered minor reform proposals in the current financial and banking landscape since the Great Recession of 2008. The key contributions reviewed will be the Dodd-Frank Act, 2010 and other additional central bank and regulatory policy changes. The other topics covered in this chapter will be recent economic policy prescriptions and their success as well as the exploration of the nascent Islamic banking industry.
Chapter three will continue the reform reviews but explore the major developments in recent history, not only in reaction to the Great Recession. These broadly include the Chicago Plan, the International Monetary Fund’s Special Drawing
Right and an in-depth review of the various gold and bimetallic standards.
Finally, in chapter four, the literature review will close with an examination of current regulatory perspectives. These include the differences between structural and cyclical policy as well as their respective applications and effects. Moreover, increasing concern over the health of the financial economy has given rise to the use of newer or previously less used terms, such as ‘macroprudential’ and ‘microprudential’. Thus, the review of this chapter explores this contemporary terminology as well as weighing in on their approach to reform
Chapter five explains the methodology used in the undertaking of this research project. It outlines the scope of study, controls, areas of concern as well as limitations encountered whilst procuring data and other information. JOOSUB 21
Chapter six is the core research analysis of the project. It analyses nine areas viewed as contributing towards severe systematic risk in the international monetary system. These areas are; money, debt, capital adequacy, credit rating agencies, accounting principles, shadow banking, derivatives, the concept of ‘too big to fail,’ and proprietary trading. This analysis is crucial as it lays the groundwork for much of the reform proposals that are to follow.
Chapter seven revisits the interesting observations made in chapter two, of the minor reform review, with regards to ethical finance and the tenets therein. Using the research from chapter two and the analysis from chapter six, an International Financial
Code is formulated with nine central articles, all of which aim to tackle the issue of systematic volatility in the financial economy. This Code will form the bulk of what is to be the final recommendations of this research endeavour.
Chapter eight takes a finer look at a bimetallic standard from the major reform ideas reviewed in chapter three. Moreover, Article II of the International Financial Code includes the use of a gold type standard in its reform proposal, which further warrants the exploration of the feasibility of the metal.
Chapter nine connects the International Financial Code with the research analysis. Therefore, allowing a reader to observe with ease which particular systematic concern from chapter six is addressed and which article does the respective addressing.
This connection helps to translate the ideas put forward in the reform proposals suggested in the body of this research.
Chapter ten takes a bird’s eye view of the recent transformation of financial institutions, once trusted custodians now struggling to maintain their perception to Main
Street. It asks the simple questions that many forget to ask when fingers are pointed and reform ideas are put head to head. This chapter also takes a much-needed objective look JOOSUB 22 at doomsday prophecies concerning the global financial system. Finally, chapter ten closes the discussion area of the project by scrutinizing the history of the IMF and its potential role as a future leader in the international monetary system.
Chapter eleven concludes this research project by briefly revisiting the current major and relevant contributions to financial reform in modern history. It then reviews the novel contributions discussed in the previous chapters before explaining their limitations and implications for future research.
The average person is no stranger to alternative frameworks for capitalism: socialism, communism or even feudalism, all of which made relative sense in the economic climates that gave birth to them. However, we have always been an evolving civilization with new needs on the horizon and this paper will attempt to explain that a reformed, rethought take on finance might indeed be more appropriate for our latest needs.
The objective of this analysis is to isolate the initiation of controversial policies that have contributed to a perceived global financial instability and unserviceable debt obligations. Moreover, this paper elaborates on the fact that revisions in economic policy since the demise of the Bretton Woods Agreements have really been minor and convoluted; having added more wires to a faulty circuit board as opposed to replacing the actual circuit board. Is it not time for a new system? By definition, if it is a “new” system we are proposing, it has to be something we cannot relate to because we have no modern references for it.
If the global economy were to be conceived of as a living organism, then we can reference French economist, Antoine Destutt de Tracy, who postulates that industrial JOOSUB 23 entrepreneurs serve as the heart.18 The blood of this organism, or body politic, is capital and therefore capital keeps industry alive by means of good banking. Central bank policy, via interest rates is one such tool; to act as a regulator for the flow of blood.
Finally, our generally accepted accounting principles are like the central nervous system: a complex structure that seamlessly sends, receives and interprets signals within the organism to ensure regular functionality and ward off viral attacks.
18 Timothy Terrell, “The Economics of Destutt de Tracy, ” Mises Daily, (2008): accessed 2 February 2016, https://mises.org/library/economics-destutt-de-tracy.
JOOSUB 24
LITERATURE REVIEW
CHAPTER 1 – HISTORICAL CONTEXT
“The man of system… seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chessboard. He does not consider that in the great chessboard of human society, every single piece has a principle motion of its own.”19 - Adam Smith (1723-1790)
(1.1) Circa 1640, Modern Banking is Born
In the colonial era leading up to and beyond the 17th Century, hoards of new exotic merchandise, as well as gold and silver, were being shipped back into Europe and
England from modern day America, but what was then called the “New World”. As a result of increasing trade between Asia and the Western world, gold was likewise flowing into Europe with silver flowing out and eastwards.20 Notable thinkers of the time, such as Sir Isaac Newton, Master of the Royal Mint, observed that merchants in
England also favoured paying foreign debts in Silver, whilst foreigners preferred paying
English debts in gold. Thus, the influx in gold caused a worrisome fluctuation between the metals used for exchange.21 Another, more day-to-day concern was where to actually safely store all this gold.
Enter the Royal Mint, a respected institution that housed public funds in the
Tower of London. This became the chosen facility by merchants and goldsmiths of the
19 Adam Smith, The Theory of Modern Sentiments (United Kingdom: Digireads, first edition 1759).
20 Alrifai, (2015), 10, op. cit.
21 Newton Isaac, “Sir Isaac Newton’s State of the Gold and Silver Coin.” Treasury Papers, 21 September 1717, accessed 9 September 2015, http://pierre-marteau.com/editions/1701-25-mint- reports/report-1717-09-25.html.
JOOSUB 25 city to store their wealth. However, in 1640 the financially troubled King Charles I seized all GBP130,000 of this money and declared it a loan – which was never repaid.22
Nine years later, he was tried and found guilty for high treason and the pursuit of his own ends over the wellbeing of the people. He was executed in 1649.
The valuable Roman distinction between fiscus (the treasure of the monarch) and aerarium (the treasury of the public finances) is by now a forgotten precedent. It was at this point that much of Western Europe lost faith in the state and its ability to safeguard the financial interests of the people. Yet before that point, the proliferation of economic prosperity in Europe as a result of colonization was fast paced and unstoppable, reliance on the Royal Mint was never in doubt. At the time, it was state sanctioned religious warfare that forced the monarch to frisk the pockets of his subjects.
Nevertheless, these events gave way to a historic transition in financial intermediation by the designation of a new means for storing gold, goldsmiths.
At the time, goldsmiths engaged in many activities such as crafting, lending and exchanging money, although they never actively took part in the storage of money. Not before long, they were accepting deposits of precious metals for a fee and issuing receipts, redeemable only by the original depositor. It is important to note that the origins of fractional reserve banking arise at the point where, in an effort to earn more money on the idle metals, goldsmiths began lending gold on behalf of their depositors, hoping to make an interest fee before the deposit was redeemed. This maturity transformation eventually seduced goldsmiths into issuing promissory notes in excess of their initial gold holdings.23
22 Scott, William Robert, The Constitution and Finance of English, Scottish, and Irish Joint-Stock Companies to 1720, (Cambridge: Cambridge University Press, 1912).
23 Alrifai, (2015), 12, op. cit. JOOSUB 26
There is a well-known problem with interest in a system that has a finite money supply. If there are only 100 units of gold in circulation and a goldsmith lends 10 units at 10 percent interest, he is to expect 11 units of gold in repayment, however, where is the 11th unit of gold to come from? This parody, when practiced more widely begins to transform money into (a title of) debt. This problem will be dealt with in more detail in later chapters, some simple solutions will also be proposed to prevent the accumulation of debt on a private and public scale.
The practice of issuing money and credit by goldsmiths created an unofficial bimetallic standard. Since the promissory notes in circulation were theoretically attached to the value of the precious metal in a vault. Each goldsmith was effectively able to issue their own ‘brand’ of currency and the level of confidence in their promise to pay determined the value of the respective currency in the market. Thus, from the seeds of mistrust in the monarch, banking in England was born. However, by 1694, the control and issuance of money, or rather currency, was taken back by the government when the Bank of England was born. From then on, banks could only issue debt.
Despite the lack of full integration, by the 17th century the global monetary system was using gold, silver and copper to some extent as the legal tender of the bimetallic standard. Be that as it may, in England the Napoleonic wars caused a considerable silver shortage that forced the Bank of England to abandon the standard in favour of a fiat currency, backed by nothing but trust in the state.
(1.2) 1880 to the Great Depression, The Golden Years of the Gold Standard
Realizing that the fiat system did not inspire the confidence needed for stable international trade and commerce, the English government intervened via the Act for the Resumption of Cash Payments in 1819. By 1844, the Bank Charter Act ensured that JOOSUB 27 the Bank of England reintroduce the convertibility system that allowed banknotes to be redeemed for gold bullion. Known as the classical gold standard, the convertibility rate was set at GBP4.24 for one spot ounce of gold.24 More nations globally opted for the gold standard over the bimetallic standard, following the example of the most powerful trading nation in the world, of course.
By 1880, global monetary integration had reached a historical peak built on the foundations of trust and security created by the gold standard. Most of the world had adopted some iteration of the gold standard. Traders and bankers entered freely into cross-border transactions with the peace of mind that resulted from the assured convertibility of gold. The economic results were phenomenal. Global trade during the late 19th century had reached inconceivable levels, egged on by world leaders who were promoting liberal policies. To facilitate the rise in trade, global infrastructure improvements leaped forward in ways not matched in any subsequent century.25
Industrialization, transatlantic shipping, railway transportation, global migration, these were all the biggest advances in civilization ever undertaken by mankind during this millennium. The current literature simply does not give sufficient credit to what a stable financial and banking system can achieve.
Even when German Chancellor Otto von Bismarck instigated what was to become a domino effect in global protectionist policies, trade still flourished. The music only stopped at the end of June 1914, when Archduke Franz Ferdinand was assassinated.
Following the tragedy of World War I, in which 16 million lives were lost, the
44 Allied Powers sought to improve financial integration and cooperation by way of
24 Alrifai, (2015), 14, op. cit.
25 Alrifai, (2015), 15, op. cit.
JOOSUB 28 increasing interdependency amongst nations. The creation of the Bank for International
Settlements (BIS), headquartered in Basel, Switzerland, was initially tasked with handling the German reparation payments following the Treaty of Versailles in 1919.
However, following WWII, it morphed into a central bank for all other central banks.
(1.3) 1944-1971, The Bretton Woods Agreement
World War II claimed 61 million lives. The gates of world powers were once again rattled to bring about firmer international integration to make the temptation of war economically inconceivable. Three major developments set the arena for the coming decades, the United Nations, the Marshall Plan and our primary focus, the negotiations of the Bretton Woods Agreement.26
The impartial view of the final achievements of the Bretton Woods Agreement is as follows. Global exchange rates were pegged to the US dollar. The US dollar was in turn convertible for gold, at USD35 per ounce. Currency fluctuations were allowed, up or down, within a bracket of 1 percent. Central banks would buy or sell their currency vis-à-vis the US dollar to maintain that peg. This is known as a gold exchange standard, quite different from a pure gold standard because real gold is not in circulation and often-denser central bank policy is involved. The International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), now known as the World Bank (WB), were tasked with upholding the Bretton Woods system. The way these developments unfolded are central to the paradigmatic issues challenged by this paper.
26 Alrifai, (2015), 18, op. cit.
JOOSUB 29
Many logically assume that one of the reasons behind the Herculean efforts of the Bretton Woods structure was that the time was ripe to create an economic climate not susceptible to the same issues that could induce a repeat of the Great Depression.
These assumptions may have been based on only one side of the story.
That being said, the 1929 stock market crash is dwarfed by the unavoidable fact that in 1944 the U.S. was not only a global hegemony, but also an economic powerhouse that needed to sustain its post-war growth by guaranteeing a strong export outlook.27 This objective is ratified by a comment made by a senior official of the Bank of England:28
One of the reasons Bretton Woods worked was that the U.S. was clearly the
most powerful country at the table and so ultimately was able to impose its will
on the others, including an often-dismayed Britain. At the time, one senior
official at the Bank of England described the deal reached at Bretton Woods as
“the greatest blow to Britain next to the war”, largely because it underlined the
way in which financial power had moved from the UK to the U.S.
The American, Harry Dexter White, walked away as the mastermind and hero who triumphed over John Maynard Keynes, the Englishman, as the ultimate architect of the Bretton Woods Agreement.29 Top down policy descriptions proved to be effective
27 Block, Fred. The Origins of International Economic Disorder: A Study of United States International Monetary Policy from WW II to the Present. (Berkeley: UC Press, 1977).
28 Senior Official of the Bank of England (1944) In The Bretton Woods Sequel will Flop by Gideon, Rachman. The Financial Times, 11 November 2008. http://www.relooney.info/0_New_3860.pdf.
29 Boughton, James, “Harry Dexter White and the International Monetary Fund,” Finance & Development Volume 35, Issue no 3. (1998): accessed 11 September 2015: http://www.imf.org/external/pubs/ft/fandd/1998/09/boughton.htm.
JOOSUB 30 since reforms needed to take place in a swift and concise manner. However, they were not without flaws and we cannot only credit hindsight for the foreseeable demise of the whole structure.
White was not a notable academic or political thinker; in fact, his largest claims to fame are the corroborated accusations that he was a Soviet spy. One could only speculate that a man of his profession would have been versed on the prosperity that followed the late 19th century gold standard. Yet we know he thought little of the gold standard per se, although ironically recognized that the US dollar could not be a reserve currency without having some backing of specie value.30 It must be noted that the concept of floating exchange rates between countries was almost implicit with trade volatility. It was therefore undesirable and not considered as an option in the slightest.
Nevertheless, the most widely accepted flaw of the Bretton Woods ‘White Plan’ was that it did not provision for increasing global trade.31 By using the greenback as a global reserve currency, the world required an ever more increasing supply of US dollars. The famous Triffin Dilemma illustrates the economically conflicting paradox faced by the United States. As a global reserve currency, they must be willing to meet the demands of foreign nations exchange reserves, thus forcing the U.S. to persistently hold current account deficits.32
The Nobel Prize winner, Joseph Stiglitz, is a well know advocate for the creation of a new global reserve currency. Yet he argues that whenever other countries purchase
30 John Tamny, “Keynes, White and the Battle of the Bretton Woods.” Forbes, 31 March 2013, accessed 12 September 2015, http://www.forbes.com/sites/johntamny/2013/03/31/keynes- white-and-the-battle-of-bretton-woods/.
31 Boughton, (1998), op. cit.
32 “Definition of Triffin Dilemma,” Financial Times, http://lexicon.ft.com/Term?term=Triffin- dilemma.
JOOSUB 31
US dollars to use on the international market they effectively give the U.S. a zero- interest loan,33 confirming the conviction that the system favoured the U.S. economy.
Keynes himself foresaw this caveat and made provisions for it in his plan by use of the
‘Bancor.’ This is not too dissimilar to what we now call Special Drawing Rights
(SDR’s), the IMF’s international reserve asset imbued with an unlimited printing capacity. That being said, we cannot currently hold too much value in SDR’s when they are still not anchored to a stable benchmark, thus remaining fiat in nature. One of the monetary reforms that will later be elaborated upon is based on a paper written by the
Governor of the People’s Bank of China (PBOC), Dr. Zhou Xiaochuan.34 It will allude to an international reserve currency that is divorced from individual nations.
Further analysis reveals that the Bretton Woods Agreement had two major drawbacks. As previously mentioned, the first is that it did not provision for increasing trade, hence the suggestion of the Bancor and thus the recent developments with the
IMF’s SDR. The second drawback as Stiglitz mentions, is that it was designed to favour one nation above others thus contributing to economic inequality. The proposals sought later in this paper are unbiased, however, they will tackle selected financial issues from the perspective that they are structural.
Under the auspices of the controversial Bretton Woods Agreement, the world still benefited from respectable trade growth. It was not until the 1970’s that inevitable cracks started to appear.
33 John Detrixhe, “Stiglitz Urges New Global Reserve Currency to Stem Imbalances” Bloomberg Business, 10 April 2011, accessed 14 September 2015, http://www.bloomberg.com/news/articles/2011-04-10/stiglitz-calls-for-new-global-reserve- currency-to-prevent-trade-imbalances.
34 Zhou Xiaochuan, “Reform the International Monetary System,” Bank of International Settlements, 23 March 2009, http://www.bis.org/review/r090402c.pdf. JOOSUB 32
(1.4) 1971 to Today, The Aftermath of the Bretton Woods Agreement
The Vietnam War forced the United States to support its military endeavours by vastly expanding their money supply. This influx of US dollars onto international markets was not without notice, naturally, and the greenback was the victim to speculative attacks. Moreover, in the late summer of 1971, president Richard Nixon suspended the exchange of dollars for gold. Realizing that this decision antagonized central banks the world over, the Group of 10 member countries (G10), the economic powerhouses of the time, met in December of 1971 in Washington D.C. to try and mitigate the damages.
The resulting Smithsonian Agreement devalued the dollar by 8 percent and allowed for the exchange of gold to be USD38 per ounce35 and was the equivalent of addressing a forest fire with bottled water. However, the Vietnam War was considered the most expensive war in Cold War era, costing nearly USD1 trillion in 2011 terms.36
Thus, even if Nixon had opted for a more creative solution, like the inclusion of silver into the gold exchange standard or substituting the dollar/gold peg for a dollar/SDR peg,
America still would not have been able to combat the economic blows of high inflation and severe trade imbalances caused by the net outflow of printed money. The demise of the gold exchange standard was unavoidable if the US dollar was to reflect accurately its decrease in purchasing power. The onslaught of war can be strongly attributed as the quickening agent of this demise.
Following 1973, most industrialized nations had allowed their currencies to float
(more or less) freely in the market. The reserve asset of choice for central banks the
35 Alrifai, (2015), 20, op. cit.
36 Alan Rohn, “How Much Did The Vietnam War Cost?” The Vietnam War, 22 January 2014, http://thevietnamwar.info/how-much-vietnam-war-cost/. JOOSUB 33 world over is still the US dollar, a fiat currency backed by the intangible promise of the
United States government.
To date, there have been no major model developments in the field of financial policy. We are living in the aftermath of the demise of one financial economic structure.
The breakdown of the Bretton Woods Agreement should have prompted the powers that be to devise a new agreement, one that recognizes the reality of past mistakes and successes. Unfortunately, this is yet to happen and history has shown no success stories when it comes to fiat currency based economies. They have all been wiped out by either hyperinflation or default.
The following chapter examines the literature relating to contemporary minor financial reforms. JOOSUB 34
CHAPTER 2 – MINOR REFORMS
“Good people do not need laws to tell them to act responsibly, while bad people will find a way around the law.”37 - Plato, The Republic (~ 428-348 BC)
(2.1) Dodd-Frank Act, 2010
As a response to the Great Recession, The Dodd-Frank Wall Street Reform and
Consumer Protection Act was signed into federal law by President Barack Obama on
July 21, 2010.38 It is the single most important piece of government-produced, financial legislation in the 21st century. It builds on the Investment Company Act of 1940 and pledged major, sweeping financial reforms that were to be felt the world over. The first page of the bill reads:
“An Act to promote the financial stability of the United States by improving
accountability and transparency in the financial system, to end “too big to fail,”
to protect the American taxpayer by ending bailouts, to protect consumers from
abusive financial services practices, and for other purposes.”39
37 “40 Famous Philosophical Quotes by Plato on Love, Politics, Knowledge and Power.” Gecko&Fly, 15 July 2016, http://www.geckoandfly.com/18829/famous-philosophy-quotes-plato-love-politics- knowledge-power/.
38 Jim Kuhnhenn, “Historic Financial Overhaul Signed Into Law by Obama.” Associated Press, 21 July 2010, accessed 9 February 2016, https://web.archive.org/web/20100722225614/http://news.yahoo.com:80/s/ap/20100721/ap_ on_bi_ge/us_financial_overhaul.
39 H.R. 4173, Dodd-Frank Wall Street Reform and Consumer Protection Act, 111th Congress, 210, 1.
JOOSUB 35
The above excerpt is embodied in sixteen titles of legislation which, to their credit, tackle most of the issues which caused the Great Recession as well as most of the structural issues analysed in this paper
Despite the grand promises of the Act, many years later, it is still a work in progress. The Dodd-Frank Five-Year Progress Anniversary Report, recently produced by law firm Davis Polk and Wardwell, has been tracking the Act. Figure 2.a below shows that of the 390 total rulemaking requirements, about 40 percent remains to be finalized, with many having already missed the required deadlines. A particularly scary observation is that laxity of the rulemaking is concentrated in the areas of derivatives, mortgage reforms and systematic risk.40
Dodd-Frank Rulemaking Progress July 15, 2015 Davis Polk and Wardwell Future Deadline: Future Deadline: Not Proposed Proposed
Missed Deadline: Proposed
Finalized Missed Deadline: Not Proposed
Figure 2.a41
To date, some of the most tangible positive effects of Dodd-Frank are that credit card companies can no longer arbitrarily move the due date of a bill. They also cannot
40 Davis Polk and Wardwell, Dodd-Frank Progress Report (New York, NY: David Polk and Wardwell LLP, 2015), 6.
41 Davis Polk and Wardwell, (2015), 2, op. cit.
JOOSUB 36 retroactively impose higher interest burdens on customers. Predatory mortgage practices have been curbed since customers can now sue lenders for poor credit risk calculation.
Banking capital buffers have been raised and transparency has increased.42
Nonetheless, it is hard to peg down any of these benefits as being truly reaped by the financial system because of the delays in enactment. Even so, many smaller banks that Dodd-Frank was aiming to empower have already complained that the new regulatory costs will remove their abilities to extend loans or simply put them out of business.43
Many of the Acts primary proponents are no longer in Congress and without even being totally enforced, it is already the victim of public scrutiny and repeal. In
May 2015, the Senate Banking Committee (SBC) approved the ‘Shelby Bill’, which is an overhaul of the Act. The implications lift the threshold that subjects bank holding companies to scrutiny from USD50 billion to USD500 billion.44 This implies that all
American institutions, with the exception JP Morgan Chase, Bank of America, Wells
Fargo and Citi Bank, will now slip through the net.45 It perhaps also offers an explanation as to why the Securities Industry and Financial Markets Association
(SIFMA), Wall Street’s number one lobby, has expressed support for the law.46 The
42 John Schoen, “Five years on, Dodd-Frank Bank Rules Still Being Written.” CNBC, 17 July 2015, accessed 9 February 2016, http://www.cnbc.com/2015/07/16/five-years-on-dodd-frank-bank- rules-still-being-written.html.
43 Institute for Economic Policy Studies, Dodd-Frank Mortgage Rules Unleash Predatory Regulators (Washington, DC: The Heritage Foundation, 2013).
44 Schoen, (2015), op. cit.
45 Federal Reserve Statistics Release, Large Commercial Banks (Washington, DC: Board of Governors of the Federal Reserve System, 2015).
46 Securities Industry and Financial Markets Association, Dodd-Frank Rulemaking Resource Centre (New York, NY: SIFMA, 2015).
JOOSUB 37
Shelby Bill also has negative implications on the Volcker Rule, which is further explored in the research analysis under the section of proprietary trading.
The debate is ongoing, but Dodd-Frank has still not made true on its biggest promise, to “end too big to fail.” The research analysis will reveal that the opposite has in fact happened, with big banks getting bigger. Moreover, the Act has been labelled as bloated and confusing,47 which might explain why it is dogged with enactment delays.
This is not an encouraging status update from what was supposed to be the most significant financial regulatory changes since the Great Depression. Abundant evidence shows that it certainly did not have the major anticipated effects and for this reason, this review suggests that Dodd-Frank is an anticlimactic disappointment.
(2.2) Central Banks and Other Regulatory Bodies
The amount of government and non-government regulatory bodies is endless. To do an audit on the scale and effectiveness on all of them would be impossible; moreover, it is outside the scope of this paper. However, it should be noted that the sheer number and spread of these regulatory institutions is already a problem. The disjointed and convoluted policies rarely meet international consensus and are not always binding to signatories, rendering these institutions to be more like ‘good will’ think tanks than enforcement bodies. Most of them are not known to even the most established figures in finance. The forthcoming analysis will be on the Joint Forum and its shortcomings. This body was selected for review because of its production of the
Basel Accords through its subsidiary, The Basel Committee on Banking Supervision
(BCBS), which is arguably the most influential banking policy framework to date.
47 ”Too Big Not to Fail.” The Economist, 18 February 2012, accessed 9 February 2016, http://www.economist.com/node/21547784. JOOSUB 38
Furthermore, the Joint Forum is a distinguished body amongst its peers dealing primarily with financial regulation and large conglomerates.
The Joint Forum is an international organization composed of regulatory representatives from three key industries: banking, insurance and securities. It includes the BCBS, the International Organization of Securities Commissions (IOSCO) and the
International Association of Insurance Supervisors (IAIS).48 For the purposes of investigating financial reform, this paper will focus more specifically on the BCBS and the Basel Accords.
The general direction of the Accords is to ensure the health of international banks engaged in lending, investing and trading. Regulatory literature was aimed at maintaining consistency in its published standards to limit competitive inequality amongst cross-border banks. As mentioned previously, the Basel Accords are not binding, unlike the Dodd-Frank Act. They are referred to as “best-practice rules,”
“standards,” or “soft laws.”49 It is at the discretion of sovereign financial regulatory bodies (central banks are also regulatory in nature) to make these standards mandatory and therefore monitored, or not. However, the first weakness identified with the Basel
Accords is that it lacks the means to enforce its recommendations, added to the fact that the systematically critical, massive shadow-banking sector falls into a grey area where any kind of regulation is concerned. That being said, many major economies, including the U.S., the UK and Germany have adopted and enforced these standards. They are the
48 “Joint Forum,” Bank for International Settlements, Last modified: January 2016, http://www.bis.org/bcbs/jointforum.htm.
49 Dieter Kerwer, “Rules that Many Use: Standards and Global Regulation,” Governance, Volume 18, Issue 4, (2005): accessed 5 October 2015, http://onlinelibrary.wiley.com/doi/10.1111/j.1468- 0491.2005.00294.x/pdf.
JOOSUB 39 most recent, legitimately acknowledged attempts at large-scale financial management since the fall of the Bretton Woods System.
The second major weakness of the Basel system is its attempts to redistribute the costs of financial regulation rather than directly address market failures. Notable scholars Thomas Oatley and Robert Nabors argue that, especially under the updated
Basel II, there is a greater tendency to encourage banks towards self-regulation.50
Former Federal Reserve Chairman Alan Greenspan was convinced of the self-regulatory nature of banks and markets.51 This school of thought was further supported by trusted academic theories, such as the Efficient Market Hypothesis (EMH). However, it is essential to note that the move towards a self-regulatory regime was born primarily because of a loss of confidence in regulators themselves.
The historical landscape of regulation has provoked two new dilemmas. The first is that big banks respond to regulation by resorting to highly innovative practices for the sake of profitability. Or, more straightforwardly, they resort to fraud. One such example is the manipulation of the London inter-bank lending rate (LIBOR) by Barclays Bank,
JP Morgan, Union Bank of Switzerland (UBS), Royal Bank of Scotland (RBS) and
Deutsche Bank.52
The second dilemma is that newer regulation tends to raise the cost of doing business for banks, which they invariably transfer on to their less than happy clients.
This creates room for financial disintermediation as it fuels what is known as the
50 Thomas Oatley and Robert Nabors, “Redistributive Cooperation: Market Failure, Wealth Transfers and the Basel Accords,” International Organization, Volume 51, Issue No 1, (1998): pages 35-54.
51 William Black, “Alan Greenspan and his Disciples are Intrinsically Terrible Regulators,” Business Insider, 16 August 2010, accessed 4 February 2016, http://www.businessinsider.com/alan- greenspan-and-his-disciples-are-intrinsically-terrible-regulators-2010-8.
52 “Libor: What is it and Why Does it Matter?” BBC News, Business, 3 August 2015, accessed 18 October 2015, http://www.bbc.co.uk/news/business-19199683.
JOOSUB 40
‘shadow-banking’ industry. This industry offers capital and services the same way regular banks do, yet because the industry is wholly unregulated, the cost of doing business for players in this market is much cheaper. The rapid growth of this unregulated financial sector is worrying for reasons beyond just instigating regular banks to partake in riskier activities. It will be further explored later in the chapter.
The crude framework of the Basel capital adequacy structure created a loss of faith amongst even the biggest supporters of the BCBS.53 The obvious problems with self-regulation, other than trust and peer review, will be made more clear when capital adequacy is explored later in the chapter.
(2.3) Ethical Attempts – Economic Policy Prescriptions
The IMS has always needed a broad based, universally accepted set of
‘collective principles’ or ‘rules of the game’ to act as the glue which holds it all together. Such a proposed adhesive is not currently present in the IMF’s Chicago Plan or in the research on further usage of the SDR. Even the gold standard, whose primary proponents such as former U.S. congressman Ron Paul or economist Murray Rothbard54 failed to supplement their ideas with an ethical foundation.
With reference to historical attempts at creating an ethically unified, international financial code, academics and economists alike will recall the Washington
53 Rethel, 2012, 76, op. cit.
54 Robert P. Murphy, “The Gold Standard: Myths and Lies.” Mises Institute, 13 June 2011, accessed 19 November 2015, https://mises.org/library/gold-standard-myths-and-lies.
JOOSUB 41
Consensus (1989),55 the Beijing Consensus (2004)56 and the Berlin Consensus (2012).57
These are the most recent and desperate intellectual attempts at reviving a dominant economic modus operandi since the fall of the Bretton Woods system. The international monetary system was in an anarchic type free-fall and so think tanks and political bodies responded with their best efforts. They all echo the same themes, of ‘fiscal discipline,’ ‘low inflation,’ ‘positive business climate,’ ‘export led growth,’ and other such philosophical aspirations. Therefore, they are all quite similar in nature, highly domestic, top-down and vague and, ultimately, they provide no reference for measuring their actual performance and no suggestions for structural economic reforms.
Consequently, it is no surprise that they did not form any lasting impressions in the international financial community. Thus, these, as well as other fleeting economic policy examples that did not gain traction can only be hailed as no more than ‘best efforts.’
A review of these past policy prescriptions has only been in the anticipation that workable examples of reform may be borrowed or adapted for a new reform proposal.
This is only possible in an instance where structural changes have been stipulated, which was perhaps most apparent in Dodd-Frank, yet unfortunately, least tried and accepted.
As part of the recommendations this research aims to produce, a new consensus will be proposed akin to the ‘10 commandments’ of finance, so that it might complement and enforce the recommendations for a new monetary system. It will differ
55 John Williamson, “The Washington Consensus as Policy Prescription for Development” (Lecture, Institute for International Economics, 1989).
56 Joshua C. Ramo, “The Beijing Consensus,” (Thesis, The Foreign Policy Centre, 2004).
57 Jean-Paul Fitoussi, Francesco Saraceno, “European Economic Governance The Berlin-Washington Consensus,” (Thesis, LUISS University, 2012). JOOSUB 42 greatly from previous attempts in that it will not be vague. As opposed to being lucidly philosophical, it will be a code of conduct inspired from a credible and existing body of literature rather than the mind of an economist or academic. Rather than taking the mercantile approach, it considers the well-being of the IMS in its totality, from Main
Street to any Fortune 500 corporation. It will not be perfect, but it will certainly promise the overdue paradigm shifts that are much needed in order to reduce global systematic risk and promote an IMS that serves the polis instead of vice versa.
The aim of this ‘international financial code’ is to uplift money, banking and finance from the gallows to which it has sunk.
(2.4) Ethical Attempts – Islamic Finance?
The increasing relevance of Islamic finance in modern banking has led to a wealth of literature dispensing information on Sharia law that is worth evaluating for the purposes of this research. It is of particular significance because of its unique qualities, which have recently earned Islamic finance rapid growth and esteem. Consequently, much like all schools of thought that develop rapidly, many misconceptions have surfaced regarding this body of knowledge regarding what it is, whom it applies to, where it comes from and why it is at all pertinent. Context has been lost and the Sharia scholars are in part to blame for the resulting public misconceptions and prejudice.
This is by no means a theological treatise; it is in fact as laic as possible. Yet to cite Sharia law because of its increasing significance in financial circles does indeed warrant further clarification of the pedigree of its lineage. Only then can its apparent popularity and effect on modern banking be comprehended.
It is generally understood that to speak of Sharia compliant finance is to reference a body of theological governing traditions, definitively from the creed of JOOSUB 43
Islam. This is completely false. To maintain this view is akin to losing site of the moon whilst counting the stars. A rudimentary understanding of religious doctrine places
Islam, along with Judaism and Christianity, inside the connected tradition of Abrahamic principles.58 To cite only a few examples, there is the fifth book of the Torah,
Deuteronomy,59 or the Gospel of Mark from the New Testament in the Bible,60 or the analogy of the spider in chapter twenty-nine of the Quran.61 All of these references confirm the continuity of the Abrahamic message.
Therefore, to speak of Sharia law, a large part of which is derived from the
Quran, as exclusively belonging to Islam, is a misapprehension that stems from an incomplete understanding of its genesis. Many experts on Islamic jurisprudence,62 relating specifically to Sharia finance, are guilty of hastily hijacking the consecrated law and proclaiming its exclusive domain within Islam. This is not to negate their wealth of knowledge and good intentions towards a socially just economy.
This clarification is not to insinuate that the principles of Sharia should govern every individual. The nub of a free-market economy is a free individual imbued with whatever standards he/she chooses to live by, given that they are law abiding. However, the clarification is intended to surface the fact that the consensus proposed in the previous chapter is in perfect harmony with Abrahamic ideals. The only reason Islam is being referenced is because modern banking is witnessing a positive resurgence in a
58 “Abrahamic Religions,” New World Encyclopedia, Last modified: 4 February 2016. http://www.newworldencyclopedia.org/entry/Abrahamic_religions.
59 The Torah, Deuteronomy 18:18, 7 BC.
60 The Bible, New Testament, Gospel of Mark, 12:35-44, 70-80 AD.
61 The Quran, Chapter 29 (The Spider), 27, 609-632 AD.
62 Iqbal Khan, “Issues and Relevance of Islamic Finance in Britain” (HSBC Amanah Finance, Institute of Islamic Banking and Insurance, 2011).
JOOSUB 44 particular area of finance labelled as ‘Sharia’ compliant. Nevertheless, it is essential that all of the ideals are understood to be similar in theme and origin, lest the consensus is misconstrued as a sectarian inspired and divisive set of tenets.
Of course, there are many who differ in their viewpoint but this is an incorrect platform for debate. To make the research as straightforward as possible, only the revelations themselves have been quoted as primary sources, to avoid comparing perspectives of the numerous learned scholars.
What is Sharia Compliant Finance?
The Golden Age of Islam was hailed as the period between the sixth and thirteenth centuries AD.63 During this period, the major Islamic capital cities such as
Córdoba, Baghdad and Cairo saw major intellectual advances in fields such as science, philosophy and medicine. This Golden Age must lend credence to the previous advances in economics made by the Persian, Indian, Chinese, Greek, and Roman civilizations.64 This segment of history served as a prelude to the European Renaissance,
Humanism and Enlightenment.
Sharia law as applied to Islamic finance, which matured from the sixth to the thirteenth century, is purported to encourage fairness, social justice and economic prosperity. In order of importance, it was built on three pillars: the Quran (114 chapters revealed from 610 AD to 632 AD), Hadith (narrative relating the actions and sayings of the Prophet Muhammad and the Sunnah, which is the life and example of Muhammad.65
63 Matthew Falagas et al, “Arab Science in the Golden age (750–1258 C.E.) and Today,” The Federation of American Societies for Experimental Biology (FASEB), Volume 20 no. 101581-1586. (2006): accessed 7 February 2016, http://www.fasebj.org/content/20/10/1581.full.
64 Alrifai, (2015), 98, op. cit.
65 Alrifai, (2015), 98, op. cit.
JOOSUB 45
For the purposes of this research, in so far as Sharia is concerned with finance, there is a strong emphasis on the prohibition of interest and speculation. Nevertheless, that is just the framework of Sharia compliant finance and it’s important not to lose site of the basic credo; economic transactions must take place in a just, responsible and free- market economy, an individual must learn to weigh his needs with that of societies. The implications of which are that worldly pursuits must be balanced with an individual’s inner integrity and finally, it asks us to remember that all wealth is only temporal.66 Life has only two things to offer that are for certain, death and taxes.
Unfortunately, the furthest most individuals identify with Sharia finance is with regards to its staunch prohibition on interest. Be that as it may, the logic behind this prohibition has been echoed by intellectuals throughout history, as was mentioned in the prologue. The issue with interest, known as riba, which directly translates from Arabic to “effortless gain,”67 is the exploitative measure of earning without shared risk.
Since the establishment of the first Sharia compliant financial institution in 1975 in the United Arab Emirates, The Dubai Islamic Bank (DIB), 700 Sharia-compliant banks have sprung up around the globe. Switzerland and Luxembourg having been some of the European pioneers in the 1980s.
The godfathers of innovation in Sharia compliant banking products are in fact
Western banks, Hong-Kong Shanghai Banking Corporation (HSBC), Deutsche Bank and Barclays68. It was through their financial wizardry that the masses can now partake in this industry, not only Muslims. During the modest days of these institutions, they
66 Faleel Jamaldeen, “Key Sharia Principles and Prohibitions in Islamic Finance,” For Dummies, 2015, http://www.dummies.com/how-to/content/key-sharia-principles-and-prohibitions-in- islamic-.html.
67 Alrifai, (2015), ??, op. cit.
68 Irfan, (2014), 69, op. cit.
JOOSUB 46 were concentrated mainly in the Middle East and Malaysia. From the 1990s up until today, Sharia compliant assets have swollen from USD150 billion to USD2 trillion.69
Furthermore, at the height of the recession in 2009, this sector of the financial industry witnessed an impressive 15 percent growth. Accounting firm Ernst & Young predicts continued year-on-year growth of 19.7 percent through to 2018.70
The significant developments in this industry have more than likely been attributed to international partiality to the concept of profit and loss sharing (PLS) as opposed to the traditional debt financing. Any transaction a modern bank can conceive of, no matter how complex, can have a Sharia compliant counterpart that adheres to the principles and has a strong element of fairness in it. Internal practices in these financial intermediaries have created a combination of low risk and high reward. Such is evidenced by favourable ratings from CRA’s, such as Standard & Poor’s, who as of
2012 awarded ratings to five of the largest Sharia compliant banks of (A-/Stable/A-2).71
The bread and butter of Sharia compliant products consist of a suite of six instruments that do not look too different from their conventional counterparts. With the exception that these instruments focus on PLS and fairness. They are:72
1. Trust financing (Mudaraba). This is similar to a relationship between a fund
investor and a fund manager. It behaves like a mutual fund or a hedge fund.
69 Alrifai, (2015), 102, op. cit.
70 “Big Interest, No Interest.” The Economist, 13 September 2014, accessed 2 December 2015, http://www.economist.com/news/finance-and-economics/21617014-market-islamic-financial- products-growing-fast-big-interest-no-interest.
71 Standard & Poor’s, Islamic Finance Outlook (London/Paris: McGraw-Hill, 2012), 21.
72 Alrifai, (2015), 137, op. cit. JOOSUB 47
2. Cost-plus financing (Murabaha). A financial intermediary buys an asset on the
client’s behalf and sells it back to him/her for a profit. It differs from a
conventional mortgage or auto-loan in that this type of transaction is actually
linked to the real economy. The only item that cannot be traded at a premium or
discount, is debt.
3. Partnership financing (Musharaka). This is equity investing, which is essentially
identical to the accustomed venture capital or private equity.
4. Leasing (Ijara). The first type is leasing with the intent to own, an operating
lease. The second type is leasing with the intent to return to the owner at the end
of a period, a financing lease.
5. Forward-sale (Bay Al-Salam). A client may pay for goods at the spot price and
agree upon delivery at a specified date in the future.
6. Construction financing (Istisna). In a typical transaction, a client would provide
the land and a bank would pay the developer for the building construction,
which is then sold back to the client for a profit via agreed upon terms.
There are a multitude of other products on the market, the most popular of which is an asset-backed bond (Sukuk). In 2013 the British government did a Sukuk offering of
GBP200 million which was oversubscribed to GBP2.3 billion. George Osborne,
Chancellor of the Exchequer, is quoted as saying:73
Today’s issuance of Britain’s first sovereign Sukuk delivers on the government’s
commitment to become the western hub of Islamic finance and is part of our
73 HM Treasury and The RT Hon George Osborne MP, “Government Issues First Islamic Bond,” Last modified: 14 August 2014. https://www.gov.uk/government/news/government-issues-first- islamic-bond.
JOOSUB 48
long-term economic plan to make Britain the undisputed centre of the global
financial system.
One of the key concepts in Sharia pertains to the definition of money. This is a crucial point because it drives home one of the reasons why Sharia has been employed by this research for building a universal consensus. Under Sharia, money is a means to an end, but not an end in itself. Therefore, money sitting idle in a bank account has no intrinsic value other than what it could be worth if it was put to economic and productive use. It is a means of exchange. It is a unit of account and most certainly not a commodity, which can be bought or sold at a premium or discount. Thus, currency trading is also not allowed unless at the spot market where transactions are immediate.74
There are no limits placed on what money can constitute. It could be gold, silver, paper money or bitcoins. They would all be acceptable under Sharia.
This paradigm distils the essence of the role of money in global trade. It uproots the fiat money archetype and lays one of the first bricks in what could construct the future international monetary system, post U.S. dollar backed fractional-reserve banking.
Notwithstanding the leaps forward that Sharia finance has made in such a short span of time, it is far from what any economist would call a mature industry.75 It is riddled with its own challenges.
One such challenge is the occasional lack of consensus in jurisprudence amongst the Islamic Scholars. These experts sit on official Sharia Supervisory Boards, which conduct their advisory in accordance with the Accounting and Auditing Organization
74 Alrifai, (2015), 123, op. cit.
75 Standard & Poor’s, (2012), 22, op. cit.
JOOSUB 49 for Islamic Financial Institutions (AAOIFI).76 Their agreement is needed to basically
‘bless’ or approve a product before a financial institution can legitimately market it as
Sharia compliant. Sadly, it is not always the case that a board’s approval meets both the letter and spirit of Sharia. Moreover, not all Sharia compliant products are marketed in order to promote a more stable international monetary system. It is more often that bankers are looking to tap new pools of under banked wealth with Sharia compliant investors instead. The same profit driven craze in regular banking that bore new and innovative products hidden with embedded risk is already starting to surface with Sharia compliant products.77
By far the biggest impediment to growth and proliferation in the principles of
Sharia are as a direct result of public misconceptions. Unfortunately, in popular culture it is not often that the words, Islam, Muslim or Sharia are painted in a positive light. The media and headlines distribute negative connotations associating those words with violence and terrorism. Needless to say, it is important to analyse the primary misconceptions and debunk any allegations if there is to be any progress in cementing a
Sharia inspired consensus.
Misconceptions
In his book, Islamic Finance and the New Financial System: An Ethical
Approach to Preventing Future Financial Crisis (2015), Tariq Alrifai has composed an
76 “Accounting and Auditing Organization for Islamic Financial Institutions,” AAOIFI, Last modified: 2014. http://www.aaoifi.com.
77 Irfan, (2014), 40, op. cit.
JOOSUB 50 up-to-date list of shortcomings and misconceptions associated with Islamic finance. He has outlined the five main points as follows:78
1. Islamic finance supports and is linked to terrorism.
2. Islamic finance is for the benefit of Muslims only and is part of Sharia’s plan for
global domination.
3. Islamic banks are not safe.
4. Islamic finance is a marketing gimmick.
5. Islamic finance cannot be a stand-alone financial system because it is too
dependent on the conventional one.
First Misconception – Islamic finance supports and is linked to terrorism
Sharia compliant banks face the same challenges that conventional financial institutions do when it comes to the issue of know-your-customer (KYC).
It was widely believed that Islamic banks facilitated the terrorist attacks in New
York on September 11, 2001. However, the most credible report on this issue from the
9-11 Commission, found that no Islamic financial institution was linked to or involved in the attacks. It further showed that the attackers used Dresdner Bank, Citibank,
Standard Chartered Bank and HSCS’s affiliate in Saudi Arabia, the Saudi British
Bank.79 Nonetheless, the most frequently used method to carry out these wires was in fact through kiosks like Western Union.
78 Alrifai, (2015), 159, op. cit.
79 National Commission on Terrorist Attacks Upon the United States. 9/11 Commission Report edited by Thomas Kean, New York. 2004. 131
JOOSUB 51
In other examples pointed out by Alrifai, skeptics argue that the Bank of Credit and Commerce international (BCCI) and the Arab Bank were directly involved in terrorist financing.
BCCI was liquidated in 1991 for a number of blatant sins. It was also used by the Central Intelligence Agency (CIA) to fund the Afghan Mujahedeen. Lieut. Col.
Oliver North famously sold U.S. weapons to Iran during an embargo and used the profits to finance the ousting of the then ruling party of Nicaragua. BCCI was a conduit.80 Yet BCCI was never a Sharia compliant bank and never claimed to be.
In September 2014, The Arab Bank, headquartered in Jordan, was found liable to be knowingly supporting terrorism (Hamas).81 Once again, this is not a Sharia compliant institution and to this day no evidence has been found to prove that Sharia compliant institutions have in any way, knowingly financed or contributed to terrorism.
Second Misconception – Islamic finance is for the benefit of Muslims only and is part of Sharia’s plan for global domination
As mentioned previously, Sharia law is a descendent of Abrahamic law, which can apply to anyone. It would be equally absurd if someone were to suggest that Coq au vin is only for French people.
The Organization of Islamic Cooperation (OIC) and its 57 member states is composed mainly of developing economies that collectively make up less than 10 percent of global GDP. Their main departments are science, economic affairs and
80 Richard Lacayo, “Iran-Contra: The Cover-up Begins to Crack.” Time, 24 June 2001, accessed 5 December 2015, http://content.time.com/time/magazine/article/0,9171,157496,00.html.
81 Stephanie Clifford, “The Cost for Arab Bank Is a Complex Calculation.” The New York Times, 23 September 2014, accessed 5 December 2015, http://www.nytimes.com/2014/09/24/nyregion/The-Cost-for-Arab-Bank-Is-a-Complex- Calculation.html?r=0.
JOOSUB 52 information technology.82 These nations lack both the resources and agenda for global domination.
In the U.S. alone, from 2008 to 2012 the FDIC forced 465 conventional banks to close their doors.83 Non-Muslims started viewing Sharia compliant banks as a safe haven due to little or no exposure to toxic assets. The Islamic Bank of Britain and
Saturna Capital, based in the U.S., are examples of which both saw an increase in their non-Muslim clients.84
Finally, respected scholars in Islamic jurisprudence will concede beyond any room for doubt that ‘global domination’ is a not concept in conformity with Sharia,85 likewise with any other Abrahamic doctrine. Any sect or group that claims otherwise, does not speak for Muslims in general and they are moreover acting outside of Sharia.
Much in the same way the Ku Klux Klan (KKK) is not a true reflection of Christianity and many would argue that it acts completely outside the faith.
Third Misconception – Islamic banks are not safe
Islamic banks would not be vulnerable to the contagion effect inherent in banking collapse should this occur again.86 Whilst being criticized for their high exposure to real estate, regulators often overlook the low exposure to toxic assets sold
82 “Departments,” Organization of Islamic Cooperation, Last modified 2015. http://www.oic- oci.org/oicv2/depts/.
83 “Failed Bank List,” Federal Deposit Insurance Corporation, Last modified: 16 November 2015, https://www.fdic.gov/bank/individual/failed/banklist.html.
84 “Non-Muslims Flock to ‘Safe-Haven’ Sharia Bank Protected from the Crunch by Non-Gambling Rule,” The Daily Mail, 6 October 2008, accessed 5 December 2015, http://www.dailymail.co.uk/news/article-1070430/Non-Muslims-flock-safe-haven-Sharia-bank- protected-crunch-non-gambling-rule.html.
85 “Articles,” Shaykh Fadhlalla Haeri, Last Modified 2012, http://www.shaykhfadhlallahaeri.com.
86 Alrifai, (2015), 170, op. cit.
JOOSUB 53 by regular banks. Indeed, their derivatives exposure is exactly zero. In the event that the
USD1.2 quadrillion derivatives market blows up; global bank reserves would be wiped out many times over. Vulnerability with Islamic banks in this scenario is limited only to deposits held in conventional banks.
In June 2012, research carried out in unison between Lancaster University and
Case Business School in the UK revealed interesting results. The paper concludes that not only are Islamic banks better capitalized than their conventional counterparts, but they are also found to be 55 percent less hazardous based on financial ratios extracted from respective balance sheets. The paper also highlights that in the event of distress, conventional banks have access to support from the state, which encourages moral hazard.87 Such is not the case for Sharia compliant banks and thus their investment decisions are more prudent.
It is no secret that most conventional big banks with a Wall Street office were selling subprime mortgages to clients whilst at the same time betting on their high chance of default. Those same mortgages were also collateralized and traded like a hot potato and this is still happening today. Sharia forbids the trading of debt and the sale of derivatives, two of the largest contributors to financial volatility. Despite appearing more ‘vanilla,’ Sharia is certainly not unsafe.
Fourth Misconception – Islamic finance is a marketing gimmick
The end result of a PLS transaction and a debt financed transaction may appear to be similar, but the former is linked to the real economy. In a conventional home or auto loan, the bank has no role in the purchase and no relationship with the seller. It also
87 Vasileios Papas et al., “Failure Risk in Islamic and Conventional Banks” (Lancaster University Management School and Case Business School, City University, 2012), 20. JOOSUB 54 does not sell an asset to generate its profit. The economics of Sharia try to promote socially just trade as opposed to money simply generating more money. Therefore, in theory, under a Sharia system the level of goods and service in an economy increases proportionately to the level of money in an economy, which offsets inflation.
It is true however that at the turn of the 20th century, many banks, Western or otherwise, did use Sharia compliance as a way to lure attractive new Middle Eastern capital into their funds. Comingling of capital is not permitted, because Sharia compliant investors are forbidden from investing in weapons, tobacco, alcohol, gambling and a list of other industries deemed to be harmful.88 These investment criteria are carefully monitored by the independently appointed Sharia Supervisory Boards. Any financial, insurance or regulatory institution may appoint a minimum of three scholars of Islamic jurisprudence should they wish to be consulted on matters relating to Sharia compliant finance. In turn, the members of the Sharia Supervisory Board follow the guiding principles outlined by AAIOFI or other accrediting agencies.89 In that sense,
Islamic finance maintains its authenticity.
However, as time has passed the scholars of jurisprudence have diverged more fervently over what can authentically be marketed as Sharia compliant. Some stay true to the credo of the law, whilst others only uphold the ‘letter’ and abandon the ‘spirit’ in favour of marketability. Justice Taqi Usmani, whose seniority and expertise has led many to revere him as the most respected of all the select jurors on Islamic jurisprudence, has openly declared much to the frustration of his peers, that the Sharia
88 Alrifai, (2015), 117, op. cit.
89 Bashar Malkawi, “A Bright Future: Towards an Enhanced Sharia Supervision in Islamic Finance,” The European Financial Review, 28 February 2014, accessed 28 March 2016, http://www.europeanfinancialreview.com/?p=487.
JOOSUB 55 asset-backed bonds, or sukuk, have gone too far in mimicking conventional debt.90 He is one such example of a scholar of jurisprudence who sits on the Sharia Supervisory
Boards of a number of international institutions such as Dow Jones, the Bahrain
Monetary Agency and the Islamic Corporation for the Development of the Private
Sector.91
Despite the internal challenges faced by the Islamic finance industry, it is without doubt a system that is not addicted to debt and abhors speculation. If that is a marketing gimmick, it certainly practices that which it preaches.
Fifth Misconception: Islamic finance cannot be a stand-alone financial system because it is too dependent on the conventional one
This misconception is in fact not a misconception. The postmodern world uses both civil and common law, Roman law being the progenitor; these frameworks were established in Europe during the Middle Ages. It is interesting to note that civil and common law were taught in universities in addition to canon law, which altogether formed the body of legal thought that our current financial system rests on.92 Sharia compliant finance is still pegged to a world that references this modern law, which now conveniently and secularly so, excludes the Church’s original cautions against usury and gambling.
90 Robin Wigglesworth, “Sharia Boards: Scholars Hold Sway Over the Success of Products.” Financial Times, 5 May 2009, accessed 7 December 2015, http://www.ft.com/cms/s/0/91c1636e-3836- 11de-9211-00144feabdc0.html#axzz3tdw3UvjC.
91 Islamic Finance Resource. “Sharia Scholars.” Last modified January 2016. http://ifresource.com/shariah-specialists-in-islamic-finance/.
92 “The Common Law and Civil Law Traditions,” The Robbins Collection, University of California at Berkeley, Last modified: 2010. https://www.law.berkeley.edu/library/robbins/pdf/CommonLawCivilLawTraditions.pdf. JOOSUB 56
Sharia compliant finance is an ecosystem within an ecosystem and it surely would not be able to survive otherwise. The 57 members of the OIC do not even fully employ Sharia law; they use a blend of common, civil, and Sharia. JOOSUB 57
CHAPTER 3 – MAJOR REFORMS
"The difficulty lies, not in the new ideas, but in escaping from the old ones.”93
- John Maynard Keynes (1883-1846)
(3.1) Solutions with a Short Shelf Life
The previous chapter covered selected minor reform proposals over the course of modern history. They have largely proven to be short lived because of the pace and manner of which global trade and financial systems developed. Moreover, their limited lifespan can further be attributed to the fact that these reforms were either convoluted, one sided, slow to take effect or received by an unmotivated audience.
This is for two basic reasons. First, financial markets are constantly in flux. It is a highly competitive and evolving environment. To survive, innovative new instruments are constantly invented for the purposes of enhancing yield. To be effective, reform needs to be piloted by the right players and it needs to be sweeping, swift and sharp, much like Bretton Woods.
The second reason for sluggish reform is deception. The illusion of mediocre to strong economic growth in the past half a century has been at the expense of massively increasing debt – not necessarily innovation or value creation.94 Therefore, the IMS has somewhat avoided pain akin to the Great Depression or even World War II, unfortunate but powerful motivators for change. It has instead limped onwards with protracted
93 Rickards, (2011), 195, op. cit.
94 “The Debt-Based Economy,” Workable Economics, Last modified: January 2016, http://www.workableeconomics.com/the-debt-based-economy/.
JOOSUB 58 mediocre to low growth, which is according to Managing Director of the IMF, Christine
Lagarde, steadily becoming the “new reality.”95
Later in this paper the research analysis will dissect systematic concerns in the
IMS that are all but mere symptoms of deeper structural issues that have been acknowledged but not yet addressed by economists and politicians.96 Targeted, countercyclical fiscal policy does not work.97 The research analysis will show that piecemeal policy making only adds to debt and burdens institutions. Moreover, the extensive regulatory requirements of the recent stabilization policies have been prohibitive to financial institutions under the category of Small to Medium Size
Enterprises (SME). That is why the purpose of this chapter is to fully examine existing major structural reform proposals that try to engage the fundamental issues of reserve assets, money creation, and debt.
Nevertheless, alternate models for banking do exist. Of all the solutions discussed by leading economists and politicians, three stand out as the most realistic – the Chicago Plan, the IMF’s SDR and the gold standard. They have been broadened recently to account for some of the developments in international finance but we must still critically evaluate their application in the context of the most imminent structural issues.
95 Christine Lagarde, in speech to the Atlantic Council (Washington, DC: 2015).
96 Alrifai, (2015), 202, op. cit.
97 Douglas Holtz-Eakin, “Structural Reforms to Reduce Debt and Restore Growth,” CATO Institute, November 2014, http://www.cato.org/publications/conference-paper/structural-reforms-reduce- debt-restore-growth.
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(3.2) The Chicago Plan
The proponents of this plan, Jaromir Benes and Michael Kumhof, have reworked the original ideas of 1929, which were conceived by Nobel Prize in Chemistry laureate 1921, Frederick Soddy. The most recent report, produced in 2012, is a working paper from the IMF’s research department. However, the first page of the working paper disclaims that it should not be reported as representing the views of the IMF.98
The original version drew significant support from notable University of Chicago economists such as Irving Fischer, Frank H. Knight, Henry Schultz and Henry C.
Simons.
Its propositions suggest the following positive economic effects:
1. Banks would no longer be able to generate funding via lending to the Federal
Reserve. They would become ‘pure’ intermediaries by obtaining funds in the
form of deposits. Control would therefore be restored to the supply of credit
which would reduce sudden ‘credit booms or busts.’
2. One hundred percent reserve ratios would remove the threat of bank runs.
However, it was for this reason that the Chicago Plan was attractive to President
Roosevelt in 1933 as a means out of the Great Depression.99 Today, the Federal
Reserve estimates that the money stock (M2) is at USD12.2 trillion.100 In the
event of a bank run or loss of deposits, the FDIC has access to the Deposit
98 Jaromir Benes and Michael Kumhof, “The Chicago Plan Revisited,” International Monetary Fund, August 2012, 1. https://www.imf.org/external/pubs/ft/wp/2012/wp12202.pdf.
99 Alrifai, (2015), 202, op. cit.
100 Federal Reserve Bank of St. Louis, M2 Money Stock (St. Louis: Economic Research, 2015), https://research.stlouisfed.org/fred2/series/M2.
JOOSUB 60
Insurance Fund’s (DIF) USD18 billion.101 It has USD19 billions of its own cash
and securities: additionally; it has the ability to borrow up to USD500 billion
from the Treasury.102 Therefore at best, only 4 percent of American commercial
bank money is insured in the event of a bank run; making 100 percent reserve
ratios look attractive.
3. The government would be allowed to issue money directly, at zero interest, as
opposed to purchasing Treasury debt securities from banks (underwriters).
Therefore, there is a reduction of interest burdens on government finances and
the Plan claims that a substantial reduction in net government debt as well as
private debt will result.
4. Full reserve backing could generate a negative net government debt position.
Thus, the government could choose to buy back private debt from banks against
the cancellation of Treasury credit. Therefore, the Chicago Plan also claims to be
able to dramatically reduce private debt.
Whilst addressing some structural issues, this proposition does have some major drawbacks. The first of which includes a lacklustre economic outlook if access to credit becomes more stringent. This could result in a further resurgence of the shadow- banking industry. There is also the issue of a potential deflationary spiral if the government plans on soaking up all the private debt. There is of course the lack of trust in public sentiment and accordingly, the probable reluctance at handing over the money
101 Federal Deposit Insurance Corporation, DIF Balance Sheet – Second Quarter 2010 (Washington, DC: FDIC, 2010).
102 Federal Deposit Insurance Corporation, FDIC Extends Restoration Plan; Imposes Special Assessment (Washington, DC: FDIC, 2009).
JOOSUB 61 creation process to any government, given their track records. Yet more instances of how positive policy can have negative collateral implications.
By far the biggest drawback of the Chicago Plan is the fact that it still leaves the systematically volatile, multi quadrillion-dollar derivatives market unchecked.103 In the event that the Chicago Plan bails out private debt, a fraction of default obligations would cancel out but a vast ocean of derivative contracts would still be left unregulated and unresolved.
It must be noted that both the Chicago Plan and the SDR, which is explored next, are the brainchildren of the IMF. Whilst some may disagree, the IMF and the
World Bank are more American institutions than international organizations. More quaintly, they are American institutions with an international mandate. The authority of internal decision-making confirms this. The U.S. holds more than 15 percent of total votes (more than any single member).104 Therefore, it not only has the muscle to steer the organization in any direction it chooses: it also has the power to veto any major decisions. They are both headquartered in Washington, DC, not too far from Capitol
Hill.
This information is important because it lends perspective in light of trying to predict the future of the IMS. The leniency of other international actors towards the
Chicago Plan and the SDR is likely to be influenced by the fact that they are perceived as American remedies.
103 Alrifai, (2015), 203, op. cit.
104 Kathryn C. Lavelle, Legislating International Organization: The US Congress, the IMF, and the World Bank (New York: Oxford University Press, 2011) 4.
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(3.3) Special Drawing Rights (SDR)105
SDRs are considered to be an international reserve asset. It is the IMF’s unit of account that is assigned a weighted value based on a basket of underlying currencies – the US dollar, euro, Japanese yen and pound sterling. The respective weights are, 41.9 percent, 37.4 percent, 9.4 percent and 11.3 percent.106
In the event that SDR use becomes greater, there are provisions for increasing the basket of underlying currencies for a more balanced denomination.107 Most recently, the IMF has approved the inclusion of China’s renminbi (RMB) in the basket as from
October 1, 2016.108 Whilst these currencies aid in the valuation of the SDR, they do not dictate or limit the quantity that can be issued (it is a unit of account, not a physical unit). Thus, the SDR theoretically gives its holder a claim to any one of the currencies held in the basket.109 Therefore, it is a fiat reserve asset, for fiat currencies.
When the SDR was created in 1969, it was valued using the weight of gold. One
SDR was the equivalent of 0.888671 grams of gold, which at the time was also the value of one US dollar.110 Yet following the fall of the Bretton Woods’s system in
1973, the IMF determined that the international supply of two key reserve assets, gold
105 ISO 4217 currency code XDR.
106 Shawn Donnan, “IMF Staff Say Renminbi Should Join Elite SDR Basket of Currencies.” Financial Times, 13 November 2015, accessed 18 November 2015, http://www.ft.com/cms/s/0/f3c0948e- 8a57-11e5-9f8c-a8d619fa707c.html#axzz3rqW9AEzu.
107 Alrifai, (2015), 204, op. cit.
108 Donnan, (2015), op. cit.
109 Patrick Chovanec, “4 Trillion Reasons China’s Currency Isn’t Ready for Prime Time,” Foreign Policy, (2015): accessed 3 February 2016, http://foreignpolicy.com/2015/06/16/yuan-renminbi- world-reserve-currency-special-drawing-rights-imf/.
110 Rickards, (2011), 220, op. cit.
JOOSUB 63 and the US dollar, proved inadequate in supporting the expansion of global commerce.
The SDR was therefore redefined as a basket of currencies.
Conversely, previous analysis has shown that it was the sudden influx of dollars onto the market from the Vietnam War, which largely contributed to the destabilization of the dollar – not a huge expansion in global commerce. In fact, the 8-year (1965 -
1973) war also forced many U.S. factories that produced consumer goods to convert production to that of military goods. As a result, consumption plunged in the United
States and the economy was only further hurt by tight monetary policy, deployed in an effort to combat the weakening dollar.111 Expanding global commerce does not inflate the global money supply, or that of a chosen reserve, at the rate that war does. The point of the evaluation is not to prove the negative economic benefits of war, but rather to prove that it is incorrect to insinuate the total inadequacy of gold as a reserve asset.
As an alternative framework for the IMS, the SDR has perhaps the least dramatic changes, which may mean that it has the highest probability of replacing the existing US dollar reserve system. This assertion was corroborated in 2011 by an internal research paper.112 The IMF made very clear its intention to elevate the SDR to the status of global reserve currency. Staying true to its word, as of November 2015, total allocations of SDR’s created and issued to all qualifying members, equals SDR204 billion (USD285 billion equivalent).113 The IMF research finding suggest that as a result of these changes the following positive effects can be expected:
111 Alan Rohn, “How Much Did the Vietnam War Cost?” The Vietnam War, 22 January 2014, http://thevietnamwar.info/how-much-vietnam-war-cost/.
112 International Monetary Fund, Enhancing International Monetary Stability—A Role for the SDR? (Washington, DC: Strategy, Policy and Review Department, 2011) 3.
113 “Special Drawing Right (SDR).” International monetary Fund. Last modified 15 November 2015, http://www.imf.org/external/np/exr/facts/sdr.htm.
JOOSUB 64
1. The SDR could “Reduce reserve accumulation/imbalances and strengthen the
global safety net.”114 It is also hailed as a lower cost alternative international
reserve than, for example, gold or silver.
2. The development of this particular reserve asset could pave the way for SDR-
denominated securities, which would offer an alternative mode of borrowing or
hedging in the event of higher demand for its resources.
3. There would be reduced exchange rate volatility. By using the SDR unit as a
currency peg, to price financial assets or to price global trade, the IMF hopes
that the SDR serves as a ‘focal point’ by which the international monetary
system can develop further. The greater the use of SDR pricing in financial
markets and global trade the greater the reduction in exchange rate volatility.
4. The SDR could offer greater participation for emerging market currencies in the
international monetary system by providing ‘smooth’ inclusion into the SDR
basket. It is expected that the SDR basket would be updated regularly to reflect
the relative importance of various currencies in international trade. However, the
report does make clear that over inclusion of the basket of currencies could
make the SDR unnecessarily complex and thus, unattractive as a reserve asset.
Many prominent individuals and organizations have come out in favour of the
SDR. At the most recent annual Bretton Woods meeting, financier and
philanthropist George Soros, rationalizes his promotion of the SDR by explaining
that:115
114 International Monetary Fund, (2011), 3, op. cit.
115 2015 Annual Meeting Luncheon, contribution by George Soros (2015; Washington, DC: Bretton Woods Committee, 2015), Audio. JOOSUB 65
“The financial crises of 2008 led to the system’s collapse… The 2008 crash was
a watershed moment because it marked the end of U.S. supremacy.”
In addition to declining U.S. supremacy, antagonism in the South China Sea and other points of military escalation, Soros strongly suggests that we are on the brink of
World War III between the U.S. and China. He reasons that making the shift towards using the SDR as a global reserve would aid in currency accommodation for China, hence the IMF’s most recent efforts. This could soften economic relations, since inclusion into the basket of currencies is a positive gesture on the global political chessboard.
Members of the U.S. Treasury as well as the United Nations advocate for the proliferation of the SDR with similar justifications.116 They acknowledge that giving the
RMB a place in the basket means that it would be viewed as desirable (as both a means of exchange and a store of value), as well as accessible (international investors can accumulate bank balances of it). Consequently, the RMB gains the exalted status of
‘safe asset’, which results in foreign demand for a wide array of Chinese investments.117
That being said, the SDR overlooks many structural issues. It does not deal with derivatives; in fact, by adding SDR denominated bonds to the pool of extant financial instruments further interest rate and credit risk is made present. To assume that they would be risk-free, would be akin to incorrectly assuming the same for sovereign bonds denominated in the current reserve asset, the US dollar. Derivative contracts are known to thrive where they can provide leverage on anything with interest or credit risk.
116 Alrifai, (2015), 205, op. cit.
117 Chovanec, (2015), op. cit. JOOSUB 66
It does not tackle the issue of money creation and fiat currency. It also has no influence over the reserve ratios of commercial banks and the practice of fractional reserve banking. Therefore, the existing compensation structures, lack of ethics and moral hazard inherent in the financial system would no doubt continue unperturbed. It would likewise prove to be inflationary since major economies would have access to further SDR allocations in times of systematic crises without necessarily having to worry about liquidating toxic assets or indebted institutions.
Scrutiny of the SDR reveals inadequacies that may prove to outweigh the purported benefits. Yet rising support for it shows an international eagerness to jump on the bandwagon of most realistic remedies to our existing ailing IMS. Conversely, this feckless stance may prove to simply be jumping out of the frying pan and into the fire.
(3.4) The Gold Standard
Gold carries with it a tremendous heritage in modern finance. That being said, in review of the current literature, no professional or academically credible resources can be found that consolidates all of the various gold standards used in the modern era of finance. This is largely because history has shown a multitude of adaptations across all nations and cultures. From the gold exchange standard of the Bretton Woods
Agreement, to the Sumerians use of gold warehouse receipts in 3500 BC – the variations are endless.118
118 Nathan Lewis, “Addressing the Notion of ‘Different’ Gold Standards,” Forbes, Last modified: April 2011. http://www.forbes.com/2011/04/08/gold-standard-dollar-opinions-nathan-lewis.html.
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Nevertheless, the existing knowledge of gold standards can be organised into three broad categories, which are limited in their detail, but sufficient enough to allow for further investigation:119
1. Gold specie standard. Gold and/or other such coins are in circulation with an
associated monetary unit of value.
2. Gold bullion standard. Gold does not circulate other than for industrial and
jewelry purposes. Authorities do agree to exchange gold bullion on demand for
currency.
3. Gold exchange standard. Gold does not circulate. Authorities guarantee a fixed
rate of exchange for another currency that is on one of the two previously
mentioned standards. This implies a de facto gold standard for the first country.
Money is therefore priced on a fixed external value only in terms of gold.
The crux of any gold or bimetallic standard is that the value of a currency is basically determined by its weight in bullion. The gold acts as a reserve, attributing value to the currency, which in and of itself is worthless. Therefore, currency is reduced to being a rudimentary means of exchange and not a store of value. Historically, gold has been viewed as playing the role of reserve asset quite well because of its rarity, durability, divisibility and fungibility.120
The most palpable benefit is that this system prevents the government from expanding the money supply in a whimsical fashion, given that they would need to
119 “What is the Gold Standard?” Gold Investing News, Last modified: October 2015. http://investingnews.com/daily/resource-investing/precious-metals-investing/gold- investing/what-is-the-gold-standard/
120 Alrifai, (2015), 198, op. cit.
JOOSUB 68 require more gold to do so. The examination on the Vietnam War suggests however, that gold, as a reserve asset may not be the best facilitator of military budget needs in wartime scenarios.
On the other hand, evidence suggests that gold is not as overly restrictive to expanding commerce as popularly touted. Its annual supply follows the same relatively smooth, linear trend, as does GDP growth.121 Despite no official gold standard agreement, all central banks hold it as an implicit reserve in addition to cash. Finally, it can be found, in varying concentrations, throughout all parts of the world.122
Moreover, and theoretically speaking, no central bank is physically needed to regulate the standard via monetary policy. The economic advantages can be summarized as follows:123
1. As a result of the difficulty governments would have in monetary expansion,
the first benefit can be seen as long-term price stability. High inflation is
unlikely in this scenario except in the event of war, or a large acquisition or
discovery of gold reserves.
2. Former Federal Reserve chairman Alan Greenspan once wrote that: “Deficit
spending is simply a scheme for the confiscation of wealth.”124 Gold type assets
do not allow for this type of scheme, in fact gold can remove financial
repression. On the other hand, Ben Bernanke was famously opposed to the Gold
121 Louis Cammarosano, “Gold Supply and Demand,” Smaulgld, 13 November 2014, https://smaulgld.com/gold-supply-and-demand/.
122 “Interactive Gold Mining Map.” World Gold Council. Last modified 18 June 2015, http://www.gold.org/gold-mining/interactive-gold-mining-map.
123 Alrifai, (2015), 199, op. cit.
124 Alan Greenspan, “Gold and Economic Freedom,” Constitution Society, (1966): accessed 10 November 2015, http://www.constitution.org/mon/greenspan_gold.htm.
JOOSUB 69
standard because it restricts central banks from increasing the money supply as
needed.125 With the current fiat system, governments can reduce their debt
obligations by printing more money to decrease the value of their currency.
This form of ‘theft’ or ‘taxation’ or ‘wealth transfer’ cannot happen under a
gold standard.
3. Finally, the gold standard reduces uncertainty in international trade and thus
also reduces the need for persistent central bank intervention by virtue of fixed
exchange rate mechanisms. Specifically, the price-specie flow mechanism, a
logical argument first made by David Hume, is an automatic check and
equivocator on trade imbalances.126 Exporting nations with balance-of-trade
surpluses eventually get more expensive as a result of inflation, whilst exports
from the original deficit nation would become less expensive as a result of
deflation. Eventually, when the deficit changes hands, gold would flow back to
the nation that had originally lost it keeping trade balances in equilibrium.
The world has not seen a true gold standard since 1914 and it is viewed in the post-modern financial system as highly draconian. Yet the economic benefits speak for themselves, leading economic historian on the gold standard, Giulio M. Gallarotti, better outlines these advantages:127
125 Ben Bernanke and Harold James, The Gold Standard, Deflation and Financial Crises in the Great Depression: An International Comparison (National Bureau of Economic Research: University of Chicago Press, 1991), 34.
126 Theodore E. Gregory, The Gold Standard and Its Future (New York: E. P. Dutton & Co., Inc., 1932) 1.
127 Giulio M Gallaroti, The Anatomy of an International Monetary Regime: The Classical Gold Standard: 1880-1914 (New York: Oxford University Press, 1995) 14.
JOOSUB 70
Among that group of nations that eventually gravitated to the gold standard in
the latter third of the 19th century (i.e., the gold club), abnormal capital
movements (i.e., hot money flows) were uncommon, competitive manipulation
of exchange rates was rare, international trade showed record growth rates,
balance-of-payments problems were few, capital mobility was high (as was
mobility of factors and people), few nations that ever adopted gold standards
ever suspended convertibility (and of those that did, the most important
returned), exchange rates stayed within their respective gold points (i.e., were
extremely stable), there were few policy conflicts among nations, speculation
was stabilizing (i.e., investment behaviour tended to bring currencies back to
equilibrium after being displaced), adjustment was quick, liquidity was
abundant, public and private confidence in the international monetary system
remained high, nations experienced long-term price stability (predictability) at
low levels of inflation, long-term trends in industrial productions and income
growth were favourable and unemployment remained fairly low.
Despite the many structural benefits of a gold standard, it is not without drawbacks. It suffers from short-run price instability because price fluctuations in the market create anxiety amongst lenders and borrowers. More apparently, there is the issue of varying distribution amongst countries. Thus, gold producers will maintain an upper hand (in the form of a potential balance of trade surplus) but be haunted by inflation. Whilst completely disabling fractional-reserve banking, it leaves the legacy of systematically dangerous derivatives unresolved. Ultimately, many economists see the gold standard as a limit on economic growth. Rather than blame poor policy decisions, central bankers conveniently use the gold standard as the scapegoat that historically did JOOSUB 71 not allow them to increase the money supply when needed (i.e. during the Great
Depression).
That being said, simple credit expansion (stabilization policy) has proven to be a deft approach to recovering from severe economic troughs, as seen with the results of
QE. One of the more rational explanations to the prolonged effects of the Great
Depression is the erroneous protectionist policy decision initiated by President Hoover in 1930. The Smoot-Hawley Tariff Act in particular, placed tariffs on more than 890 foreign goods, digging the U.S. and the world deeper into a trading rut.128
The question of whether or not we can ever return to a gold standard is difficult to answer. The money supply has expanded so drastically since 1914 that to expect 100 percent reserve backing is expensive and maybe even unrealistic.
However, global power brokers appear to be taking precautionary steps in the direction of an expected financial collapse and an ensuing return to some form of bimetallic standard. In his book, Currency Wars, James Rickards has compiled a chronological list of events, summarized in Figure 3.a, which exposes a common thread, abandoning the US dollar as a reserve currency in favour of gold:129
Timeline of Events Indicating Shift Away from U.S. Dollar (2008-2010) Currency Wars – James Rickards 2011
Date Media Resource Event
28/10/2008 Interfax Vladimir Putin advises Chinese premier to abandon US dollar as reserve.
15/11/2008 Associated Press Iran converts financial reserves into gold.
19/11/2008 Dow Jones China targets four thousand tons for official gold reserve holdings.
128 U.S. State Department, Smoot-Hawley Tariff Act (U.S. House of Representatives: 1929).
129 Rickards, (2011), 165, op. cit.
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9/2/2009 The Financial Times Gold bullion transactions reach all-time record.
18/3/2009 Reuters UN body calls for abandonment of US dollar as reserve currency.130
30/3/2009 Agence France Presse Russia and China are cooperating for the creation of new global reserve currency.
31/3/2009 The Financial Times China and Argentina enter currency swap agreement that replaces US dollar with Chinese yuan.
26/4/2009 Agence France Presse China calls for global monetary reform and replacement of U.S. dollar as leading reserve currency.
18/5/2009 The Financial Times Brazil and China explore bilateral trade without using US dollar.
16/6/2009 Reuters BRIC members call for, “Diversified, stable and predictable currency system.”
3/11/2009 Bloomberg India purchases USD6.7 billion of IMF gold to diversify reserve holdings.
7/11/2012 World Bank (WB) WB states that G20 should employ gold as international reference point for, inflation, deflation and future currency values.
13/12/2010 Press Conference Nicolas Sarkozy calls for wider role of the SDR in the international monetary system.
15/12/2010 Business Week China and Russian call for an end to dollar’s role in world trade and launch yuan-ruble trade currency settlement mechanism. Figure 3.a
The major instigators are beyond any doubt China and Russia, two major hoarders of gold. This confirms George Soros’ allegations that U.S. supremacy has been encroached upon by new global powers. The world stage has changed dramatically since the first blueprints of the Bretton Woods Agreement. The playing field has been levelled. It was easy for America to impose its will on the rest of the world since it was
130 UN Department of Economic and Social Affairs. World Economic and Social Survey 2010: Retooling Global Development, http://www.un.org/en/development/desa/policy/wess/wess_current/2010wess.pdf. JOOSUB 73 an economically and militarily superior force. Now that there are competing actors, the world can expect that the new international monetary regime will look quite different. JOOSUB 74
CHAPTER 4 – REGULATORY PERSPECTIVES
“Let me put it simply… there may be a contradiction between the interests of the financial world and the interests of the political world… we cannot keep constantly explaining to our voters and our citizens why the taxpayer should bear the cost of certain risks and not those people who have earned a lot of money from taking those risks.”131
- Chancellor Angela Merkel (2010)
(4.1) Structural Versus Cyclical
Cyclical fluctuations in any economy can be generally understood as alternating periods of contraction and expansion in aggregate demand. These periods last for approximately 18 months. At the peak of a cycle, consumer and corporate spending expands and at the trough of the cycle, aggregate demand likewise contracts.
Cyclical fluctuations in an economy can be a signal reflecting one of two occurrences. The first could be fluctuations in aggregate demand caused by individual business cycles in industries such as manufacturing, agriculture or real estate. The second could be fluctuations in an economy based on much deeper structural flaws, the latter being the more serious of the two. Skilled monetary or fiscal policy recognizes the difference between cyclical phenomenon and structural economic flaws and therefore recommends the appropriate policy, which is often a combination of the two.
The research analysis will attempt to show systematic issues that have arisen out of financial policy objectives that almost deny the existence of structural issues. The corrosive effect on aggregate demand, caused by an increasing widening in the income gap is one such proof of structural issues in the developed world. Figures 4.a and 4.b
131 Rickards, (2011), 125, op. cit. JOOSUB 75 serve as a stark reminder of the need to restore a balance to the distribution of wealth amongst global populations.132
Global Population for Adults at Various Levels of Income (October 2010) Credit Suisse Research Instituate: Global Wealth Report
0% 8% Net Worth Over USD1,000,000
Net Worth of USD100,000 to 24% USD1,000,000 Net Worth of USD10,000 to USD100,000 68% Net Worth Under USD10,000
Figure 4.a
Global Wealth Shares for Adults at Various Levels of Income (October 2010) Credit Suisse Research Instituate: Global Wealth Report
4% Net Worth Over USD1,000,000 16%
Net Worth of USD100,000 to 36% USD1,000,000 Net Worth of USD10,000 to USD100,000 44% Net Worth Under USD10,000
Figure 4.b
A degree of old fashioned Keynesian style stimulus may be necessary, a form of which is demonstrated by QE. This type of policy has been advocated strongly by many
132 “Inequality Data and Statistics,” Inequality. Last modified, 2012,http://inequality.org/inequality- data-statistics/. JOOSUB 76 proponents,133 but it has been ineffective by itself in creating lasting economic stability.
With such a high concentration of wealth, less than 10 percent of the world’s population controlling 79 percent of the world’s wealth, there is inadequate aggregate demand for all the goods and services that an economy is capable of producing.134 Representing such a small part of the population, the wealthy have a relatively smaller propensity to consume. Whereas the middleclass, comprising the bulk of the global population, will inevitably end up spending a much higher proportion of their income on goods and services and ultimately be a more significant component of aggregate demand. The adverse effects that wealth inequalities have on aggregate demand are independent to the social unrest and frustration that such pronounced class stratification can and does have.
What exactly is structural reform policy and how is it beneficial? In a 2009 paper entitled, Structural Reform at a Time of Financial Crises, the Organization for
Economic Co-operation and Development (OECD) described several policy examples.135 The policy examples discussed in the paper are in the context of trying to enhance GDP; they are renovating the public infrastructure, increasing expenditure on active labour market policies, reducing the tax burden on labour income and reforming any anti-competitive obstructions in the market. Common themes are that all the proposed solutions are top-down with the government as the focal point of reform.
Another focus is on GDP and initiating changes that will have system-wide effects. The
133 Frank Van Lerven, “Who are the Prominent Academics Who Advocate a Different Type of QE?” Positive Money, 7 January 2016, https://positivemoney.org/2016/01/who-are-the-prominent- academics-who-advocate-a-different-type-of-qe/.
134 Robert Reich, “Structural Problems or Cyclical Downturn?” (Centre for Latin American Studies, University of California, Berkeley, 2009).
135 Organization for Economic Co-operation and Development, Structural Reform at a Time of Financial Crises (Paris, France: OECD, 2009), 19.
JOOSUB 77 following excerpt from the OECD paper, offers a deeper insight that explains the relationship between structural reform and economic crises:136
“…Past experience shows that structural reforms are often initiated in times of
economic crises. This is the case even if it is easier to cope with adjustment costs
of reform when the economy is strong. Among the reasons for this pattern is that
crises unmask weaknesses in existing policies that were hidden by cyclical
buoyancy, and the associated mood of public anxiety reduces part of the
resistance to change.”
Despite the strong posited benefits of structural adjustments, history has shown that they are not all created and applied equally. The best examples of structural changes which failed to reduce volatility in the IMS is evidenced by certain evaluations earlier in this chapter, i.e. the Dodd-Frank Act, the Basel Accords, the Washington
Consensus, the Beijing Consensus and the Berlin Consensus.
These failures can be attributed to a lack of simplicity in the policy proposals, a lack of sweeping consensus and implementation amongst regulatory institutions and a number of other reasons. Further justifications for their failure can be found in the fact that these policies had an obsession on changes relating specifically to GDP. As if the
GDP metric stands as the sole measure of a country’s success, almost likening a nation to a corporation. There are numerous other indicators that can shed light on the state of a country, i.e. Human Development Index (HDI), Corruption Perception Index (CPI),
Index of Economic Freedom (IEF), Global Peace Index (GPI) and income inequality or
136 Organization for Economic Co-operation and Development, (2009), 19, op. cit. JOOSUB 78 even the simplest question which asks, are the population happy, healthy and with peace of mind?
Ultimately, none of the reform proposals described in the Minor Reforms section of this chapter suggested a viable alternative to the post Bretton Woods’s situation.
Their structural adjustments were found to be too shallow and not brave enough to challenge the standard economic order of things. Their failure and continuing failure can be likened to digging for gold, but being satisfied upon discovering the worm.
The research analysis will attempt to further indicate that to a great degree, financial institutions display a tendency to be immune to certain policy reforms. They moreover have grown into an industry that is unique in its integration and significance to all global economic and political spheres. The result of the abnormally large impact the financial industry can have on other industries and the welfare of the global economy as a whole has meant that they are systemically important. As a consequence, the prosperity of all other sectors in an economy is contingent on the successful regulation of financial institutions.
(4.2) Macroprudential Versus Microprudential
It is widely accepted that the term ‘macroprudential’ was first put into use in the late 1970’s, around the time of the demise of the Bretton Woods Agreement. The BIS estimates that it was first used by the Cooke Committee which was a forerunner of the present day BCBS.137 Nevertheless, in the aftermath of the Great Recession of 2008, it was used more frequently in policy circles as the paradigm shift reflected the need for regulatory frameworks that mitigate the risk of the financial system as a whole.
137 Bank of International Settlements, The Term “Macroprudential”: Origins and Evolution (Basel, Switzerland: BIS, 2010), 59.
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A working paper from the BIS has created a concise picture, which distinguishes the differences between macroprudential policy frameworks and microprudential policy frameworks. Figure 4.c shows the perspectives put forward in the working paper by
Claudio Borio of the Monetary and Economic Department at the BIS.138
Macro and Micro Prudential Perspectives Compared February 2003, Bank for International Settlements
Macroprudential Microprudential
Proximate objective Limit financial system-wide Limit distress of individual (systemic) distress institutions
Ultimate objective Avoid output (GDP) costs Consumer (investor/depositor) protection
Model of risk Endogenous (in part) Exogenous
Correlations and common Important Irrelevant exposures across institutions
Calibration of prudential In terms of system-wide In terms of risks of individual controls distress: top-down institutions: bottom-up Figure 4.c
It can be deduced from this data that the objective of macroprudential policy is to limit the system-wide risk of losses significantly associated with the real economy as a whole. Microprudential supervision however, focuses more on the balance sheet of an institution to achieve its objectives, i.e. liquidity, capital adequacy and leverage ratios.
The end goal is the protection of the consumer/depositor, which is arguably the same as in the macroprudential framework. Thus, at the centre of this review is the role and
138 Claudio Borio, Bank for International Settlements, “Towards a Macroprudential Framework for Financial Supervision and Regulation?” (Basel, Switzerland: Monetary and Economic Department, 2003), 2.
JOOSUB 80 function of macroprudential reform policy since the hypothesis is focusing on reducing systematic risk as opposed to market risk.
The term ‘systemic risk’ gained perhaps even more popularity in the recent years following the Great Recession than did the term ‘macroprudential’. Although a sophisticated understanding of it is often unavailable, it is most commonly used to refer to single event that can cause destabilization in an industry or economy, for example, the bankruptcy of Lehman Brothers. On the other hand, ‘systematic risk,’ is a much better understood term by academics and professionals as referring to the aggregate market risk.
Borio complements his examination of macroprudential regulatory factors with a unique explanation of systemic risk – which is essential in order to conclude that a macroprudential reform framework is in fact the appropriate remedy for the IMS. He surmises in three points that the commonly held view on systemic risk is as follows:139
1. First and foremost, it is the failure of individual institutions that contribute to
widespread financial distress. The contagion effect then provokes further
proliferation of failures in the financial system in general. The
interconnectivity via balance sheets as well as overreactions from market
participants based on imperfect information are key channels of distress.
2. The risk can be understood as arising through endogenous mechanisms – or
the relationship between financial institutions and others within the real
economy. Although in some cases of financial distress, the initial shock is
viewed as exogenous.
139 Borio, (2003), 5, op. cit. JOOSUB 81
3. The financial system is initially viewed as vulnerable. Confidence is fragile.
Therefore, in the event of an exogenous shock, the effects are amplified by
the endogenous responses of market participants.
Borio continues by pointing out various flaws in the commonly held view on systemic risk. It does not account for the causes in the initial vulnerability in the IMS. It moreover does not identify contributing factors as having culminated over the long run.
Likewise, when a bathroom floods because of a burst pipe, it is likely that the pipe has been rusting over the course of many years. The solution is naturally to change the pipe, but to change it to another pipe of superior quality to avoid another burst. This incomplete view of risk in the literature lends the assumption that related reforms generally do not target causes, but rather effects.
Basel III claims to be a good example of macroprudential policy. The BCBS further recognizes the systematic significance of financial institutions.140 Yet, their policy reforms such as countercyclical capital buffers, leverage caps and improved liquidity requirements do not lead to any structural reforms whatsoever. Contrary to their claims, the data in figure X would suggest that Basel III is more microprudential in its supervisory nature.
The desired objectives of macroprudential policy cannot be achieved via the frameworks proposed in Basel III. By the manner in which risk was interpreted and responded to in Basel III and the Basel Accords collectively, it can be assumed that the proposed reforms aim to mitigate structural failures in the IMS. However, the stated reforms hope to achieve this by incorrectly targeting the effects of structural
140 Claudio Borio, “Rediscovering the Macroeconomic Roots of Financial Stability Policy: Journey, Challenges, and a Way Forward,” Annual Review of Financial Economics Volume 3. 87-117 (2011), 1.
JOOSUB 82 deficiencies, i.e. low CAR, high leverage and poor liquidity. Real structural changes to the economic fabric have to be implemented for more tangible macroprudential results to be recognized and to limit system-wide risk. Such structural changes, however varied, can be evidenced by the Chicago plan, the SDR and a gold standard. They all share the proximate objective of reducing system-wide risk. Through various top-down ideological changes, they all ultimately hope to improve the IMS, which in turn will improve GDP. They acknowledge the interconnectedness of the IMS to the real economy and that endogenous factors are relevant in predicting and evaluating risk.
The ethical extractions from the concepts of Sharia finance prove to a degree, their macroprudential and microprudential economic attributes. For example, economic system-wide distress is mitigated by the suggestion that financial transactions are linked to the real economy, as opposed to debt based. Institutional distress is also limited by a suite of Sharia compliant products that marginalize speculative behaviour. It is certainly a financial system relying on distinct structural differences to the traditional one. By using a whole suite of new financial products and adhering to a completely polarized set of values compared to those of the traditional financial industry, the ultimate objective of consumer/depositor protection is realized. The realization is however in the form of a top-down calibration through the frameworks of Islamic financial institutions themselves. This does lend the ethical concepts a macroprudential disposition, yet the overall effect on GDP cannot be tested since these organizations do not operate in a system-wide fashion. Despite being a beacon for moral reform, their existence is still to a great degree contingent on traditional banks, yet this paper will present further research in chapter seven that shows their positive endogenous contributions to the finance industry as a whole. JOOSUB 83
The most recent recession had proved the systemic nature of financial institutions and their activities. Thus, the sledgehammer approach of traditional monetary policy can be seen as a less targeted or surgical approach than macroprudential reforms. Moreover, the preoccupation with improving GDP as the end goal to financial reform leads to misguided policy recommendations that tend only to tackle the effects of structural failures. Good macroprudential policy will most certainly have structural alterations and thus, microprudential benefits as a consequence. JOOSUB 84
METHODOLOGY
CHAPTER 5 – RESEARCH APPROACH
“An investment in knowledge always pays the best interest.”141 Benjamin Franklin (1706-1790)
(5.1) Selection Criterion
The view that money, debt and derivatives are the crippling antagonists of our financial economy is no longer a deviation from the norm.142 They have extensively influenced our range of banking products, our accounting principles and, as a result, the economic and corporate pecking order.
The rigidity of the system has also caused many scholars and advocates of reform to lose motivation, since the most apparently beneficial reform proposals, i.e. the
Chicago Plan of the IMF, require structural changes that simply cannot be advanced within the current framework. Unfortunately, it would appear as though only a complete financial meltdown will lend the attention necessary for financial reorganization.
If there is a case to be made for financial and monetary reform, then it is best done in the spirit of the American jurist and pragmatist, Oliver Wendell Holmes Junior, who once told a class at Harvard Law School, “to make a general principle worth anything, you must give it a body. You must show in what way and how far it would be
141 “An investment in knowledge always pays the best interest,” Philosiblog, 17 January 2013, http://philosiblog.com/2013/01/17/an-investment-in-knowledge-always-pays-the-best-interest/.
142 Harris Irfan’s correspondence with Mohammed Amin in response to a review of Tarek El Diwany, Islamic Banking and Finance: What It Is and What It Could Be (1st Ethical Charitable Trust, 2010). http://www.mohammedamin.com/reviews/islamic-banking-and-finance-editor-tei-diwany.html.
JOOSUB 85 applied actually in a system… Finally, you must show historic relations to other principles, often of a very different date and origin.”143
The following chapter will address the current landscape of systematic financial issues, symptomatic of deeper structural failures. There are many destructive practices although the methodology of this research seeks to analyse only issues that are deemed to contribute towards systematic volatility in the IMS. In the vein that Holmes proposes, the respective reform proposals will be evaluated in light of the potential reforms listed in the literature review.
The nine issues that have been identified for further analysis are: money and its creation, debt and fractional reserve banking, capital adequacy, credit rating agencies, accounting principles, shadow banks, derivatives, the ‘too big to fail’ concept and proprietary trading. They have provided a concentrated selection of issues which this research will aim to prove are symptomatic of flaws which can only be addressed through structural changes contained inside either the Chicago Plan, The SDR or the gold standard. They moreover present a balance between old issues, such as money creation and debt, versus up to date and recurring issues such as capital adequacy and derivatives.
They have been chosen simply because they serve as a direct side effect of little to no structural adjustments in the IMS. Paul Volcker further corroborated all of the aforementioned aspects of the financial landscape as being critical in the unfinished agenda of the reform effort.144
143 The Essential Holmes: Selections from Letters, Speeches, Judicial Opinions, and Other Writings of Oliver Wendell Holmes Jr. Edited by Richard A. Posner. (Chicago: University of Chicago Press, 1992).
144 Paul Volcker, “Financial Reform: Unfinished Business,” The New York Review of Books, 24 November 2011, accessed 7 October 2015, http://www.nybooks.com/articles/archives/2011/nov/24/financial-reform-unfinished-business/.
JOOSUB 86
After careful consideration, this study has selected to omit from its analysis certain issues that are of varying relevance to the research hypothesis. Such issues include, but are not limited to: cyber security, Customer Relationship Management
(CRM), compensation packages and student/auto loans. The omission of these particular topics subjugates the overall analysis to few if any shortcomings. It is acknowledged that the aforementioned omissions are indeed of pertinence to the IMS. Yet the objective of this enquiry was to produce deeper and more focused analysis that may reveal solutions that can reduce volatility in the IMS. The objective was not to produce and evaluate a broader birds-eye-view of the IMS. Concluding that further research into these areas will not significantly aid in proving the hypothesis.
Secondary sources of data were used to support the study of the nine selected systematic issues. Secondary information came from sources such as public Acts or bills, The Federal Reserve Bank of St Louis, Statista, textbooks, 10-Q filings or academic journals. Complete information can be found in the reference list. This data, largely being numerical in nature, and of a vast and broad quantity could not be collected as a primary source because of timing and budgetary constraints. Moreover, to partake in data collection of a primary nature when credible, secondary data is available, would turn the research evaluation into a data collection exercise.
Nevertheless, it is fully recognized that there are certain limits imposed on research by the sole use of secondary data. Such limits include, but are not limited to, lack or relevance, lack of timeliness, lack of accuracy and lack of credibility.
To mitigate against the potential shortcomings of secondary data, only high- quality reputable sources have been referenced. Furthermore, the selected data for reference benefits from larger samples sizes, which would otherwise be impossible to collect on a primary basis. This strength effectively increases the validity of the JOOSUB 87 assumptions made from data analysis. Finally, an accompanying note will prompt the reader in any instance where a respective analysis may be the subject of inaccuracies as a consequence of secondary data. JOOSUB 88
RESEARCH ANALYSIS
CHAPTER 6 – EXAMINATION OF LANDSCAPE
“Many people take no care of their money till they come nearly to the end of it, and others do just the same with their time.”145
- Johann Wolfgang von Goethe (1749-1832)
(6.1) Money
The foundation of the modern economy as we know it is money, more specifically, fiat money. Despite President Nixon’s decision to suspend convertibility of
U.S. dollars for gold in 1971, the American dollar has still reigned supreme as the global reserve currency of choice for over 70 years. Yet the resulting fiat money regime is only 45 years old and some sources indicate that fiat regimes typically do not last longer than the average human lifespan.146
Ever since 1993, a reputed guide for monetary policy throughout most major central banks has been the Taylor Rule,147 otherwise known as the ‘interest rate rule’, as seen in the equation below:
(1)
145 “Johann Wolfgang von Goethe,” Goodreads, Last modified: January 2016, https://www.goodreads.com/author/quotes/285217.Johann_Wolfgang_von_Goethe.
146 Gold Investing News, (2015), op. cit.
147 John Taylor, “Discretion Versus Policy Rules in Practice” (Public Policy, Stanford University, 1993), 202. JOOSUB 89
In this widely adopted rule, is the short-term nominal interest rate, the federal funds rate in America and the base rate for the Bank of England in the UK. The rate of inflation is as measured by the GDP deflator. The assumed equilibrium real interest rate is shown by, and the desired rate of inflation is represented by . The logarithm of real GDP output is shown by whilst the logarithm of potential output is shown by
. In this equation, Stanford University economist John Taylor recommends as a rule of thumb that both and should be positive. More specifically, he suggests that the real interest rate should be set at 1.5 times the rate of inflation. Translated more simply, the rule recommends ‘tight’ monetary policy, or higher interest rates when inflation is higher than desired and ‘loose’ monetary policy, or lower interest rates to increase inflation as and when desired.
The Taylor Rule is shown to be weak at influencing the supply of money. In fact, it suggests an incomplete understanding of credit creation. Benes and Kumhoff have suggested in their research that the volume of credit in an economy is dependent on the lending standards of individual banks,148 not necessarily monetary policy. The
Federal Reserve has exercised its stabilization policies recently via unusually loose monetary policy in order to meet inflation targets and lift the American economy.149 Yet
Benes and Kumhoff have had their assumptions confirmed by the recent anaemic economic growth and consistently paranoid markets.
The question then must be asked, ‘Who creates the U.S. dollar and how is its supply regulated?’ Interestingly enough, it is not exactly the Federal Reserve. Whilst
148 Benes and Kumhoff, (2012), 32, op. cit.
149 “Yellen Warns U.S. Financial Conditions Have Worsened.” BBC NEWS, 10 February 2016, accessed 12 February 2016, http://www.bbc.com/news/business-35540132.
JOOSUB 90 central banks the world over may be responsible for issuing currency backed by government promises to pay, they are not responsible for directly putting it into circulation. The Federal Reserve, as well as other central banks, only has at its disposal monetary tools, such as the control of interest rates or open market operations (OMO), although it is commercial banks that facilitate the actual injection of this money into the economy through credit creation.
Every time a home is purchased or a credit card is swiped, the purchase is booked by a bank as a loan.150 Thus, the fractional reserve system has added new money to your checking account, ex nihilo. Or to put it more accurately, the money was created out of debt. One of the peculiarities of this is that paper money simultaneously becomes an asset for the party holding it and a liability for the bank producing it.151 As long as banks maintain their reserve ratios, currently set at 8 percent in the Basel Accords, they are free to create as much credit as the money multiplier permits, i.e. 1/0.08 = 12.5 times the money on deposit.
This dynamic is not being arbitrarily isolated and criticized. It has proved to be a problem and the velocity of money – the rate at which money changes hands – is one such metric that illustrates unforeseen consequences of short-sighted stabilization policy.152 Figure 6.a shows the historical velocity of US dollars using M2 (cash, savings and timed deposits) as a point of reference.
150 Alrifai, (2015), 193, op. cit.
151 Rickards, (2012), 64, op. cit.
152 Federal Reserve Bank of St. Louis, Velocity of M2 Money Stock, retrieved from FRED, 29 October 2015, accessed 5 November 2015, https://research.stlouisfed.org/fred2/series/M2V#.
JOOSUB 91
Velocity of (M2) Money Stock 1958-2014 Federal Reserve Bank of St. Louis
2.3 2.2 2.1 2.0 1.9 Ratio 1.8 1.7 M2V 1.6 1.5 1959 1961 1964 1966 1969 1971 1974 1976 1979 1981 1984 1986 1989 1991 1994 1996 1999 2001 2004 2006 2009 2011 2014 Year
Figure 6.a
An increasing rate generally indicates a healthy and growing economy whilst a declining rate can be associated with economic recessions.153 Figure 6.a suggests the most obvious question, ‘Why has the velocity of money collapsed in light of multi- trillion-dollar government QE?’ A rallying stock market has also given the impression of economic recovery and increased spending.
Nonetheless, instead of lending out all of this cheap money to help generate economic growth, banks are simply re-depositing it at the Federal Reserve for a lower, but guaranteed return. The Board of Governors of the Federal Reserve has also assumed that QE has created a “substantial improvement in the outlook for the labour market” and that there is “sufficient underlying strength in the broader economy.154 Although
153 Alrifai, (2012), 184, op. cit.
154 Board of Governors of the Federal Reserve System, Press Release, 29 October 2014, date accessed 5 November 2015, http://www.federalreserve.gov/newsevents/press/monetary/20141029a.htm.
JOOSUB 92 that is an exaggeration at best, since the latest figures from the Bureau of Labor
Statistics (BLS) indicate that there are currently no fewer than 20 million unemployed
Americans and about 44 million Americans on food stamps.155
Moreover, instead of hiring more workers or increasing productive efficiency, the new corporate craze is to do stock buy-backs, multi-billion dollar mergers or multi- billion-dollar bond issuances for debt repayment or compensation distribution.156 This provokes higher asset valuations, which is reflected in the stock market, but it is not necessarily a reflection of higher Main Street investing and spending. Had the QE funds entered the economy as initially anticipated, America would be suffering from hyperinflation.157
The previously mentioned economists, Michael Kumhof and Jaromir Benes, have been active in presenting their proposal to revoke the money creation abilities of banks. In a presentation at the London School of Economics (LSE) in 2013,158 Kumhof and Benes explain that the unsupervised and inexhaustible private money creation by big banks is the reason for economic crises coupled with violent business cycles. They further explain that only under the control of government and with 100 percent reserve ratios, can we prevent the creation of money from nothing and restore balance to the
IMS.
Already, moves are being made to curb the money creation and speculative abilities of banks. During the year 2016, the Swiss federal government has agreed to
155 Bureau of Labor Statistics, Labor Force Statistics from the Current Population Survey, 5 November 2015, date accessed 5 November 2015, http://data.bls.gov/timeseries/LNS14000000.
156 Steve Shaefer, “Is Corporate America’s Debt Binge A Ticking Time Bomb?” Forbes, 1 June 2016, accessed 21 June 2016, http://www.forbes.com/sites/steveschaefer/2016/06/01/is-corporate- americas-debt-binge-a-ticking-time-bomb/#323429c0f6d5.
157 Rickards, (2011), xv, op. cit.
158 The Chicago Plan Revisited, directed by Michael Kumhof and Jaromir Benes (2012; Washington, DC: London School of Economics, 2013.), Visual JOOSUB 93 hold a plebiscite, after more than 100,000 signatures were obtained within 18 months calling for the sole powers of money creation to be restored to the Swiss National Bank
(SNB).159 Banks will be required to hold 100 percent reserves against their deposits and they will only be able to lend via savings or timed deposits. The move is expected to prevent asset bubbles and reckless lending.
Modern money, or commercial bank money, defined as a digitally created asset entered into a checking account by commercial banks, is a new phenomenon. This addictive regime, which puts the status quo on credit firmly into the hands of private institutions, has a dubious outlook given the conflicting agendas at large. Profit maximization is the modus operandi of all large corporations; conversely, central banks are interested in achieving price stability and maximum employment. When some of these contradictions are highlighted, it is easier to see the irony in trying to achieve reduced volatility in the IMS. A structural reform plan has to put the long-term interests of the many over those of the few special interest groups if it is to be effective.
Before advancing onto structural issues with systematic implications, the modern debt paradigm must be further dissected.
(6.2) Debt
For any economy to grow fast, it must do so on the back of debt/credit. All kinds of debt, government, corporate and consumer have grown at an alarming pace since
1971.160 Interestingly enough, this year, 1971, also marked President Nixon’s decision
159 Mehreen Khan, “Switzerland to Vote on Banning Banks From Creating Money.” The Telegraph, 24 December 2015, accessed 11 February 2016, http://www.telegraph.co.uk/finance/economics/11999966/Switzerland-to-vote-on-banning- banks-from-creating-money.html
160 Alrifai, (2015), 182, op. cit.
JOOSUB 94 to remove any gold backing from the U.S. dollar. Figure 6.b shows that since that pivotal decision, GDP growth in the United States has massively diverged from debt growth. Which translates into the fact that one dollar of new debt in the financial economy today does not yield the same economic growth as it once did. This diminishing return on credit161 demonstrates not only the immense devaluation of the dollar, but also how poor stabilization policy decisions involving more debt, i.e. QE, cannot possible be expected to aid in the growth of an ailing financial system.
U.S. GDP Growth vs Total Public Debt 1966-2015 Federal Reserve Bank of St. Louis
200,000 180,000 160,000 140,000 120,000 100,000 80,000 USD Millions 60,000 40,000 20,000 - 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015 2018 Year
GDP Total Public Debt
Figure 6.b
One instance of a slight decline in the overall debt was during the panic of 2008.
This resulted in what is now known as the Great Recession, which was felt all over the world. Declining debt is directly linked to a declining money supply, since new commercial bank, fiat money can only be issued on the back of new debt. Central bankers are not entertained in the slightest by the notion of falling debt because falling
161 Alrifai, (2015), 183, op. cit. JOOSUB 95 debt means financial crises to them. Debt must always rise for the U.S. as well as the rest of the world to enjoy even a hint of economic growth and therefore we must come to the reality that this debt, at least the vast majority of it, cannot be repaid and never will.
To understand the root cause of this exponential ascent in debt we must understand the basic premise of fractional-reserve banking, the money multiplier. Figure
6.c shows how an expansion of money works using the money multiplier and a theoretical amount of USD100 in cumulative deposits at any typical commercial bank.
Expansion of USD100 Through Fractional-Banking Money Multiplier = Cumulative USD Deposits/Reserve Ratio MM = 1/RR 1,100 1,000 900 800 700 600 USD 500 Money supply from cumulative 400 deposits of $100.00 300 200 100 50% 40% 30% 20% 10% Reserve Ratio
Figure 6.c
As the potentially required reserve ratios decrease from 50 percent down to 10 percent, no physical new money is actually being created. Total assets in reserve will always equal the original amount; however, new credit is created through commercial bank loans on the back of these initial, miniscule deposits. Even with a generous 50 percent reserve ratio the money supply can be effectively doubled through bank loans!
As mentioned previously, current reserve ratios sit at around 8% with adjustments in
Basel III only pertaining to the quality of reserve capital. JOOSUB 96
Central banks can merely adjust this potential liquidity via the provision of base money (reserve asset) to central banks, the demand of which will vary depending on the interest charged by the central bank in question. As of 2016, global interest rates are historically low, thus we should expect that demand for cheap credit should be high. Yet from the perspective of a commercial bank, its decision to extend the supply of credit will also rest on its ability to securitize and resell those loans.
Base money acts as a large part of the numerator in the money multiplier formula, which as Figure 6.c shows, influences the total amount credit that can be made available. It is important to note that the ceiling of the credit supply in an economy is ultimately dependent on the prerogatives of commercial banks and their willingness to extend credit. On the other hand, should a central bank decide to shrink its provision of base money, commercial banks have no choice but to revise down their credit expansion activities so that their reserve ratios are in compliance.
Therefore, it is oddly enough the non-policy variable of base money on hand that dictates the ceiling of the short-run money supply.162 From a pragmatic perspective, tangible economic policy indicators such as employment statistics, nominal GDP and rate of inflation should dictate the short run money supply.163
Figure 6.c is a stark technical exhibition of how divorced governments and central banks are from money creation and control, and thus, how easy it is for credit to spiral drastically out of control. The prophetic creators of what we perceive as money are indeed private banks. Professor Emeritus at Northwestern University’s Kellogg
162 Robert W. Dimand, “100 Percent Money: Irving Fisher & Banking Reform in the 1930s”, Vol. 1, No. 2. (1993): 59-76.
163 “Control of the Money Supply,” Boundless Business, Last modified: July 2015. https://www.boundless.com/business/textbooks/boundless-business-textbook/the-functions-of- money-and-banking-21/money-as-a-tool-123/control-of-the-money-supply-571-3193/
JOOSUB 97
School, Albert Rappaport, declares that the primary prerogative of corporate America is to enhance and protect shareholder value.164 There is nothing wrong with that per se, but these corporate prerogatives should not also govern short and long run monetary policy.
Some scholars even go so far as to declare that the fractional-reserve banking system should be outlawed and criminalized. Notable economists from the Austrian
School of thought, including Murray Rothbard165 and Jesús Huerta de Soto,166 advocate for nothing less than full reserve banking and they postulate that anything less amounts to fraud on the part of banks. However, industry wide criticism on fractional reserve banking is nothing new, nor can one suggest that it is only isolated academic or intellectual sects that depose the notions of this banking regime. Alternatives have been put forward, but none have gained the popularity or circumstances needed for application.
(6.3) Capital Adequacy
Figure 6.d shows a condensed summary of the developments of the Accords since their inception in 1988 with Basel I. Basel III, depicted in Figure 6.f, was the
BCBS’s response to the financial crises of 2007: it does not supersede the previous accords, it adds to them whilst trying to deal more specifically with the issue of bank runs. Paul Volcker has since argued that capital adequacy of banking institutions has become a key question in reform circles.167 The ongoing desire to strengthen the
164 Albert Rappaport, “Ten Ways to Create Shareholder Value,” Harvard Business Review, September Issue. (2006): accessed 3 February 2016, https://hbr.org/2006/09/ten-ways-to-create- shareholder-value
165 Murray N. Rothbard, In Search of a Monetary Constitution (Cambridge, MA: Harvard University Press, 1962), 94-136.
166 Philipp Bagus, Austrian Business Cycle Theory: Are 100 Percent Reserves Sufficient to Prevent a Business Cycle? (Auburn, AL: Ludwig von Mises Institute, 2010) 2.
167 Volcker, 2011, op. cit. JOOSUB 98 somewhat weak Capital Adequacy Ratio (CAR) of roughly 8 percent for American banks is torn between establishing a solid buffer for times of crises and meeting shareholder profitability expectations.
Basel I (1988)
Best Practices
Risk Weighted Asset (RWA) Tier 1 Capital Tier 2 Capital Classification Categories
0%, cash, government and central Core capital a bank must Supplementary or buffer bank debt maintain in relation to its capital that a bank must assets hold
0%, 10%, 20%, or 50%, public Comprised of disclosed Comprised of undisclosed sector debt reserves, common stock reserves, subordinated debt and retain earnings and revaluation reserves
20%, various development bank Bank must maintain Tier 1 and Tier 2 Capital Adequacy debts Ratio (CAR) of at least 8%
50%, residential mortgages
100%, private sector debt
CAR = (Tier 1 + Tier 2)/RWA Figure 6.d168
Basel II (2004-2008)
Best Practices
“Three Pillars”
Minimum Capital Supervisory Review Market Discipline Requirements
Credit Risk Management framework for Requires institutions to systematic risk, pension risk, disclose details on scope of strategic risk, reputational application, capital risk
168 Basel Committee on Banking Supervision, “Overview of the New Basel Capital Accord,” Bank for International Settlements, (2001): 13-33
JOOSUB 99
risk, liquidity risk and legal exposure, risk assessment risk process and capital adequacy
Operational Risk Establishment of Internal Disclosures done twice Capital Adequacy annually, penalty’s and Market Risk – Value at Risk Assessment Process rewards associated with (VaR) (ICAAP) prudent disclosure Figure 6.e169
Basel III (2015-2019)
Best Practices
Capital Requirements Leverage Ratio Liquidity Requirements
Increased Common Equity Banks are expected to The Liquidity Coverage Tier 1 (CET1) holding to maintain a minimum non- Ratio is supposed to require 4.5% risk based leverage ratio in banks to hold enough High Mandatory “capital excess of 3% Quality Liquid Assets conservation” buffer (HQLA) to cover total net Discretionary “counter- cash flows over 30 days cyclical” buffer
(CET1/RWA) ≥ 4.5% (Tier 1 Capital/Total LCR = (HQLA/Total net Exposure) ≥ 3% liquidity outflows over 30 days) ≥ 100% Figure 6.f170
The leading positive examples on capital adequacy can be seen in Swiss banks under the regulation of the Swiss Financial Market Supervisory Authority (FINMA).
UBS and Credit Suisse, the country’s two biggest banks have had imposed new capital adequacy ratios of 19.2 percent and 16.7 percent respectively.171 These new rules are in direct response to the financial crisis and an attempt to avoid a repeat of the near
169 Basel Committee on Banking Supervision, “International Convergence on Capital Measurement and Capital Standard,” Bank for International Settlements, (2004): part1, part 2, part 3.
170 Basel Committee on Banking Supervision, “Basel III,” Bank for International Settlements, (2010): accessed 7 February 2016, http://www.bis.org/bcbs/basel3/b3summarytable.pdf.
171 James Shotter, “UBS and Credit Suisse Issued With Revised Capital Standards.” Financial Times, 7 May 2014, accessed 18 October, 2015, http://www.ft.com/cms/s/0/04e6337e-d5bc-11e3-83b2- 00144feabdc0.html#axzz3ov8jXyU6.
JOOSUB 100 collapse of UBS because of its U.S. subprime mortgage exposures in 2008. Despite the fact that these requirements are only provisional and they may change as the bank’s balance sheets evolve, they appear to be sincere, remedial steps in the right direction.
A major concern, if not the only concern for other bankers are the effects that these stricter controls can have on profitability. It is therefore important to note that since the imposition of higher capital adequacy controls, UBS has suffered only a 2.3 percent decline in its net income from 2013 to 2014.172 Credit Suisse has been having considerably more difficulty, but for reasons other than higher capital adequacy ratios.
The bank has plans to internally restructure its investment banking division, a problematic earner which has been deemed to consume too much of its investors’ capital. Additionally, a new CEO, Tidjane Thiam, was brought on in the summer of
2015 with the high hopes that he could navigate the banks successful future.173
According to the Washington based Centre for Economic Policy and Research
(CEPR), capital adequacy is a historic point of contention that has once again roused interest in regulatory circles. The most obvious current conflict of interests, not spoken about too frequently, is created by the latest methods dictated for capital adequacy.
Figure X shows that under Basel III, capital adequacy is defined as the minimum capital requirement via the ratio of common equity tier 1 capital over risk weighted assets
(CET1/RWA). If financial institutions are able to underreport risk, their risk weights will accordingly be lower. Therefore, it follows that for a given level of eligible capital, a misreporting bank will appear to be better capitalized than a bank that chooses to
172 “UBS Group AG Income Statement Period Ending December 31, 2014.” Yahoo Finance. Last modified 16 October 2015. http://finance.yahoo.com/q/is?s=UBS+Income+Statement&annual.
173 Laura Noonan, “Robust Credit Suisse Results Leave Thiam With Bigger Challenge,” Financial Times, 21 April 2015, accessed 18 October 2015, http://www.ft.com/cms/s/0/4a959872-e81e- 11e4-894a-00144feab7de.html#axzz3ov8jXyU6.
JOOSUB 101 report risk truthfully. Moreover, under the standard assumption that equity financing is more expensive than debt financing, it logically entails that underreporting risk would allow a financial institution to reduce its financing costs.174
The current regulatory framework encourages banks to conceal the true nature of their risk exposure. Therefore, regulatory agencies will never really be able to gauge the systematic risks that financial institutions pose, even with the most advanced stress testing. The lack of clean data may always make these firms appear healthier than they are.
As of January 2014, the final rules of Basel III laid out specific standards for risk weighting assets.175 Although uniform global adoption is still pending, this has been hailed as the greatest improvement to bank capital adequacy since Basel I of 1989.
Within the final rules, some assets have been given stricter weighting protocols, whilst others, such as residential mortgages, remain largely unchanged. This is a scary fact given that subprime loans are making a strong return to the balance sheets of banks in prominent parts of the world.176
To meet the stricter risk-weighting standards, banks continue to introduce innovative products with weights of zero, but significant imbedded volatility. The products in demand, securitized debt and sovereign debt theoretically have a risk
174 Mike Mariathasan and Ouarda Merrouche, “Capital Adequacy and Hidden Risk,” VOX Centre for Economic and Policy Research, 29 June 2014, accessed 31 March 2016, http://www.voxeu.org/article/capital-adequacy-and-hidden-risk.
175 Basel Committee on Banking Supervision, Regulatory Consistency Assessment Programme (RCAP) Assessment of Basel III Regulations (United States of America: Bank of International Settlements, 2014), page 5.
176 Rupert Jones, “Sub-Prime Mortgages Make Surprise Comeback in the UK.” The Guardian, 30 October 2015, accessed 3 November 2015, http://www.theguardian.com/money/2015/oct/30/sub-prime-mortgages-make-surprise- comeback-in-the-uk.
JOOSUB 102 weighting of zero.177 Securitization automatically reduces an assets risk weighting under
Basel III. However, we know from the most recent financial crisis that these packaged products tend to be cunningly disguised and highly toxic and, in a globally volatile market, sovereign debt default is not as rare as it should be.
There is research to show that banks need not fear higher capital buffers, they can in fact protect their profitability with more prudentially adequate frameworks. In a speech delivered to Bloomberg in London, Andrew Bailey, deputy governor of the
Prudential Regulation Authority (PRA), draws on data from the IMF and the BIS when he says the following:178
These empirical results are intuitive and accord with our supervisory experience,
namely that a weakly capitalised bank is not in a position to expand its lending.
Higher quality capital and larger capital buffers are critical to bank resilience –
delivering a more stable system both through lower sensitivity of lending
behaviour to shocks and reducing the probability of failure and with it the risk of
dramatic shifts in lending behaviour.
Bailey’s analysis appears to be in conflict with the general view amongst bankers that higher capital requirements will reduce the overall availability of credit in the market as well as negatively affect their bottom line. However, from an intuitive perspective this research is based on past observations of markets during financial
177 “Basel III Third Time’s the Charm?” The Economist, 13 September 2010, http://www.economist.com/blogs/freeexchange/2010/09/basel_iii.
178 Andrew Bailey, “The Capital Adequacy of Banks: Today’s Issues and What we have Learned From the Past.” The Bank of England, (speech delivered to Bloomberg, London, 10 July, 2014) http://www.bankofengland.co.uk/publications/Documents/speeches/2014/speech745.pdf.
JOOSUB 103 crises. Thus, it seems only logical for banks to take measures that ensure the availability of credit and protects their ability to continue profitable operations in the event of market turbulence.
Therefore, capital adequacy continues to be a weakened and unevenly applied standard amongst ‘macroprudential institutions,’ broad-market oversight being evidently lacking. Even more worrying is that application of these ‘self-regulatory’ reforms, as we have seen from Basel III, or any type of regulation for that matter, only motivates banks to pursue riskier investments or transfer the cost of regulation onto their customers.
(6.4) Credit Rating Agencies (CRA)
Reliance on institutional and national ratings decreed by an oligopoly of dominant credit-rating agencies is at best, a dubious practice.179 Lack of sufficient competition exists in many industries, but it is of particular concern when related to the
CRA industry because incumbent players lose the much-needed consistent motivation to prove their independence, diligence and merciless accuracy.
Numerous investigations have already proven corruption and bribery within the echelons of the most powerful CRA’s.180 One recent example is a case of a Moody’s employee who confessed the degree of corruption inside the firm. William Harrington worked for Moody’s for eleven years and in his letter to the SEC, dated 8th August
2011, he highlighted the following internal conflicts of interest:181
179 Volcker, (2011), op. cit.
180 Al Franken, “Wall Street Rating Agencies’ Corrupt System.” CNN, 19 August 2011, accessed 9 February 2016, http://www.cnn.com/2011/OPINION/08/19/franken.rating.reform/.
181 Henry Blodget, “Moody’s Analyst Breaks Silence: Says Ratings Agency Rotten to Core With Conflicts,” Business Insider, 19 August 2011, accessed 31 March 2016, http://www.businessinsider.com/moodys-analyst-conflicts-corruption-and-greed-2011-8. JOOSUB 104
• Moody’s ratings often do not reflect the true opinions of its analysts. Moody’s
compliance officers do everything possible to make their clients happy, or risk
losing their business.
• Analysts who act contrarily are viewed as “troublesome.”
• Moody’s product managers, who have client-facing responsibilities, participate
in the ratings processes.
• Finally, at least one senior executive has lied under oath at the hearing into CRA
conduct.
Amongst the concerns mentioned in Harrington’s letter, the key conflict of interest is identified as the ‘issuer pays’ model, whereby the client, private or public, who desires a rating on a particular product or service, is responsible for paying the
CRA.182 The resulting model can and has culminated in a worst-case scenario, which was the financial crash of 2008. In Section 932(a)(4) of Dodd Frank,183 the sales model issue has been specifically addressed and remedied, however, the market concentration ratio of the dominant CRA players has only increased since.
Figure 6.g shows the most up-to-date market share of all twenty-three registered
CRA’s. Three firms control 91% of the market. The Dodd-Frank Act touched upon the huge need for improvement of universal internal standards in the summer of 2010.
However, as mentioned in the literature review, many years later much of the promised reforms still have an uncertain future.
182 Council on Foreign Relations, The Credit Rating Controversy (Washington DC: CFR, 2015).
183 U.S. Securities and Exchange Commission, Section 932 Credit Rating Agencies (Washington DC: SEC, 2015). JOOSUB 105
Credit Rating Agencies Market Share European Securities and Market Authority, 2014
AM Best Europe-Rating Services Ltd.
ARC Ratings, S.A.
ASSEKURATA Assekuranz Rating-Agentur GmbH Axesor S.A.
BCRA-Credit Rating Agency AD
Capital Intelligence (Cyprus) Ltd
CERVED Group S.p.A.
Creditreform Rating AG
CRIF S.p.A. Standard & Poor’s Fitch Group, 16% Group, 40% Dagong Europe Credit Rating Srl DBRS Ratings Limited
Euler Hermes Rating GmbH Moody's Group, European Rating Agency, a.s. 35% EuroRating Sp. Zo.o.
Feri EuroRating Services AG
Fitch Group
GBB-Rating Gesellschaft für Bonitätsbeurteilung mbH ICAP Group SA
Moody's Group
Scope Credit Rating GmbH
Spread Research SAS
Figure 6.g
Rating agencies represent an underrated industry (pun excused). They are essential because they define the quality of business entities and issuances in the mind of the public. A deficiency of healthy competition by market share is widely viewed as the predominant problem within this industry.
However, most Fortune 500 companies will have their stock and debt rated by multiple rating agencies. Goldman Sachs frequently issues a user-friendly report that highlights its ratings from five different agencies.184 That being said, actionable
184 “Goldman Sachs.” Goldman Sachs Credit Ratings. 25 July 2015. http://www.goldmansachs.com/investor-relations/creditor-information/gs-entity-rating.pdf. JOOSUB 106 investment decisions are typically made off ratings from only the blue-chip agencies, based on perceived reliability. Regardless of how many agencies have issued an opinion on Tesla, for example, the only easily available review on media outlets is from
Standard and Poor’s.185 This illustration points to a deeper issue amongst CRA’s: as a result of individually disjointed ratings processes there is an abundance of room for subjectivity and bias. Moreover, no matter how many new entrants there are to the CRA industry, perceived reliability will hardly shift from the oligopolies.
(6.5) Accounting Principles
Amongst the more obvious sources of loopholes and confusion in international finance is the non-uniform adoption of variegated accounting practices. Most of the developed world uses the International Financial Reporting Standards (IFRS) whereas the U.S. is still in the process of phasing out of the Generally Accepted Accounting
Principles (GAAP). Yet, financial breakdowns and their severity on the economy do point to a more urgent need for international coordination and convergence than is currently being exhibited.
A larger body of the existing literature that addresses the shortcomings in accounting practices deals primarily with the slow adoption of newer accounting measures. For example, The U.S. is still phasing out GAAP, yet Europe is preparing to phase in IFRS 9 by 2018.186 Members of the G30 are particularly concerned with the
185 “Bloomberg.” Tesla Gets Unsolicited Junk Rating on ‘Niche’ Position, 27 May 2014, http://www.bloomberg.com/news/articles/2014-05-27/tesla-gets-unsolicited-junk-grade-from-s- p-on-niche-position.
186 “Banks Should Not Be Able to Game Accounting Rules,” Financial Times, 2 September 2015, accessed 8 October 2015, http://www.ft.com/cms/s/0/80335484-5172-11e5-b029- b9d50a74fd14.html#axzz3ny7ysa6R.
JOOSUB 107 fact that the groundwork for accounting reform had already been laid down a decade ago, yet the SEC is still digesting the new potential standards.187 Chair of the SEC,
Mary Jo White, is quoted as saying that IFRS integration into U.S. financial reporting remains a priority and she “hopes to be able to say more in the relatively near future.”188
The delays in the adoption of new reforms ought to be the smallest concern amongst advocates for financial stability. In fact, the most dangerous accounting practices, shifting assets from one book to another and not fully recognizing losses, practices that ultimately contributed to the financial crisis of 2008, have been addressed weakly in IFRS 9.
Prior to 2008 and during a good economic climate, banks were able to list assets on their trading book as marked-to-market, allowing them to book and show profits even if unrealized. During a financial slowdown, the opposite occurred. Assets were shifted onto loan books that allowed them to avoid having to show heavy losses or higher potential risks. To make matters worse, under International Accounting
Standards 39 (IAS 39), banks were under no obligation to fully provision for losses against these assets unless impairment was shown in the form of a missed payment.
This practice works to directly undermine the objective of risk weighting assets for the purpose of capital adequacy. Since mortgages on a balance sheet are given a rather heavy risk weighting anywhere above 50 percent, the loan loss provisions need to realistically reflect the possible losses that could be incurred by riskier assets – but they do not.
187 Volcker, (2011), op. cit.
188 PricewaterhouseCoopers, “IFRS and US GAAP: Similarities and Differences,” (2015): page 20, accessed 8 October 2015, http://www.pwc.com/us/en/cfodirect/assets/pdf/accounting- guides/pwc-ifrs-us-gaap-similarities-and-differences-2015.pdf.
JOOSUB 108
Nevertheless, despite the multifarious makeup of the newer standards in IFRS 9, they still only require a bank to provision against the potential losses estimated over a
12-month period, not the full lifetime of the loan, regardless of the claims in the new
‘three-stage process for loan loss provisioning.’189
Included in the subject of accounting practices, but not limited to it, is the issue of taxation, more specifically the debt-equity tax bias. A 2012 taxation paper from the
European Commission concluded that tax-bias distorts the capital structure of firms in an unhealthy manner, offering the eventual possibility of profit-shifting via the transfer of debt and capital misallocation via tax arbitrage.190
This is in lieu of the Modigliani-Miller theorem, which holds that under certain conditions,191 firms are indifferent about where or how they obtain financing. The theorem further states that the value of an unleveraged firm is equal to the value of a leveraged firm: VL = VU. The research paper confirms that in reality, tax accounting systems incentivise firms to deviate from this and thus firms are clearly more biased toward debt financing. This is because of the tax shield financing of debt, where the tax shield equals the amount of debt times the corporate tax rate: VL = VU + tD.
Consequently, whilst risking bankruptcy, a firm could theoretically augment its value by being 100 percent debt financed.
Empirical evidence does indeed suggest that the degree of leverage a firm carries is influenced by tax structures. Furthermore, although the debt-equity bias may not have
189 Richard Crump, “Banks Take A Forward View of Losses Under New IFRS Rule,” Accountancy Age, 25 July 2014, accessed 8 October 2015, http://www.accountancyage.com/aa/news/2357327/banks-take-a-forward-view-of-losses-under- new-ifrs-rule.
190 Serena Fatica et al., “The Debt-Equity Tax Bias: Consequences and Solutions” (Working paper N.33 – 2012, European Commission, 2012), 3-16.
191 For example, the absence of agency costs, bankruptcy costs, asymmetric information and taxes.
JOOSUB 109 caused the finance crises of 2008, by encouraging firms to digest massive debts it certainly contributed to it.
The special nature of banking and its systematic importance urgently demands tougher, universal accounting standards.
(6.6) Shadow Banking
The term ‘shadow banking’ has been originally ascribed to Paul McCulley, an
American economist and former Pacific Investment Management Company (PIMCO) managing director. He defined shadow banks as the financial segment that has activities outside the balance sheets of regulated commercial banks and other conventional depository institutions.192
The Financial Stability Board (FSB) describes shadow banks as entities not too dissimilar from regular banks. They engage in both maturity and liquidity transformation, which essentially means they borrow short in the form of cash and invest long in the form of ‘harder-to-sell’ assets.193 However, they do not fall under any traditional banking regulation. They therefore do not have the ability to borrow from the
Federal Reserve in the event of an emergency and they do not have access to Federal
Deposit Insurance Corp, (FDIC) coverage for the protection of their funds. Thus, they remain in the “shadows.”
The problem of shadow banks is manifold. First, their lack of any regulation makes them systemically destabilizing by unpredictable orders of magnitude. Second,
192 Bryan J. Noeth, Rajdeep Sengupta, “Is Shadow Banking Really Banking?” (Federal Reserve Bank of St. Louis, 2011).
193 Laura Kodres, “What is Shadow Banking?” Finance & Development Volume 50, Issue No. 2 (2013): accessed 9 October 2015, http://www.imf.org/external/pubs/ft/fandd/2013/06/basics.htm.
JOOSUB 110 they are responsible for diverting deposits away from the regulated banking industry to the point where these institutions – hedge funds, money-market mutual funds (MMMF), structured investment vehicles (SIV), private equity funds and much more – are now larger than regular banks by deposits.194 This financial disintermediation puts pressure on regulated banks to compete for depositors by offering riskier yield curves composed of highly leveraged assets. We may think that we are safe from the machinations of dubiously leveraged assets since conventional banks fall under the umbrella of regulation, yet the FSB looks more closely at where funds come from and where they go. It does not measure the amount of debt used to purchase assets.195
The progressive rise of shadow banking is the direct embodiment of financial disintermediation. In other words, they create a disturbance in the intermediation between lenders and borrowers that is normally provided for by traditional banks. To survive, traditional institutions are thus forced to compete for clients against lower cost and sometimes dicier capital markets.196
Further fuelling disintermediation is the fact that massive corporations such as
General Motors197 (GM) and General Electric198 (GE) now also offer financing services coupled with their industry specific expertise. These circumstances have coerced banks into transforming from market authorities to market participants.199 Their struggle to
194 Rethel, (2012), 58, op. cit.
195 Kodres, (2015), op. cit.
196 Rethel, (2012), 3, op. cit.
197 “About GM Financial.” GM Financial. Last modified, January 2016. https://www.gmfinancial.com/about-us.aspx#.
198 “Tailored Solutions to Match Your Needs.” GE Capital. Last modified January 2016. http://www.gecapital.com/en/our-solutions.html?gemid2=gtnav0100.
199 Rethel, (2012), 3, op. cit.
JOOSUB 111 find yield and meet shareholder expectations explains the recent waves of financial innovation. The highly complex and imbedded volatility of products currently sold on the market present an economically lethal challenge, potentially outside the scope of any existing reforms.
Shadow-banking products and services have permeated every corner of the banking world. In a difficult economic climate, this sector is vulnerable to bank runs, as evidenced by the Lehman Brothers bankruptcy after one large fund suspended payments. The systemic ripples of this crunch were felt throughout the global economy since the vast majority of regulated financial institutions had “shadow” like, highly leveraged, toxic, falsely rated products on their balance sheets. Winding up these products that were created in murky water to begin with turned out to be extremely costly and challenging.
(6.7) Derivatives
Contrary to popular belief, the Great Recession of 2008 was not caused by the mismanagement of subprime mortgages in the United States. The practice of securitization does have its faults but, in actuality, the unregulated derivatives market brought on the calamity.200 Credit default swaps (CDS) and collateralized debt obligations (CDO) were the primary culprit contracts.
In 2000, the total size of the CDS market was roughly USD100 billion. By 2004, it was USD6.4 trillion and by 2007, it was a mind boggling USD45.5 trillion.201 When default rates of these contracts rose to levels above those that were modelled in typical banking scenarios, the scheme toppled over on itself. The lack of any regulation made
200 Alrifai, (2015), 62, op. cit.
201 Alrifai, (2015), 61, op. cit.
JOOSUB 112 these instruments a major issue, since a CDS was an insurance against the failure of a
CDO; connecting the two parties became a highly complex and nearly impossible task.
This is where AIG got into deep water. Their USD85 billion bailout was only to help administer their CDS payments,202 a painful reminder of how deeply interwoven both shadow-banking and regulated banking are.
The derivatives market is still largely unregulated. The only hopes this market has had of reform were in the pages of the Dodd-Frank Act, which as mentioned in the literature review, is tied up in political and administrative battles. Consequently, there remains a widespread notion in the financial community that derivatives are too complicated to understand; therefore, because we cannot adequately assess their risk, we cannot adequately regulate them. This is simply untrue. The magnitude of derivatives losses of 2008 dwarfed any subprime mortgage related losses, a mere
USD300 million compared to USD6.4 trillion.203 These ramifications were succinct and expensive examples of the dangers of systematic risk, a key theme throughout this paper.
Yet when we look at the changes from Basel I to Basel III concerning the recommended risk weighting for over-the-counter (OTC) derivatives, we see that the previous far from prudent 50 percent ceiling has merely been removed. Allowing a financial institution to assign a risk weight anywhere from 0 percent to 200 percent.
Considering that the world’s nine largest banks have a cumulative derivative exposure
202 Alrifai, (2015), 62, op. cit.
203 Alrifai, (2015), 62, op. cit.
JOOSUB 113 of over USD 200 trillion204 (three times the nominal world GDP, according to the World
Bank), how do we suspect that they will weight those assets?
Sadly, the current financial landscape is still lacking sufficient regulation of these dizzying contracts. European Market Infrastructure Regulation (EMIR) is one such regulative regime put forward by the Financial Services Authority (FSA), which claims to regulate the OTC derivatives markets. Its focus, as with other regulatory bodies is on reporting, clearing, collateral and counter-party risk.205 That being said, as of 2010, the current notional value of the derivatives market is USD1.2 quadrillion!206
This is twenty times the size of the world economy; a number few can truly comprehend. Furthermore, as recently as 2015 we can reference the increasing volume of derivative trades, most of which fall outside the regulative jurisdiction.207 In any one- month of 2015, total trades of futures and options by currency, exceeded total annual global GDP.208 209 It is clear that regulators are focusing more on facilitation as opposed to regulation.
204 Ben Duronio, “How 9 Banks are Exposed to USD200 Trillion Worth of Derivatives,” Business Insider, 24 April 2012, accessed 4 November 2015, http://www.businessinsider.com/9-banks- combine-for-over-200-trillion-derivatives-exposure-2012-4?IR=T.
205 “One Minute Guide – EU Regulation on OTC Derivatives (EMIR),” Financial Conduct Authority, 12 September 2014, http://www.fca.org.uk/firms/being-regulated/meeting-your-obligations/firm- guides/emir.
206 Peter Cohan, “Big Risk: USD1.2 Quadrillion Derivatives Market Dwarfs World GDP.” Daily Finance, 9 June 2010, accessed 21 September 2015, http://www.dailyfinance.com/2010/06/09/risk-quadrillion-derivatives-market-gdp/.
207 Mayra Valladaes, “Derivatives Market Growing Again, With Few New Protections.” The New York Times, 13 May 2014, accessed 10 February 2016, http://dealbook.nytimes.com/2014/05/13/derivatives-markets-growing-again-with-few-new- protections/?_r=0.
208 “Exchange Traded Futures and Options, by Currency,” Bank for International Settlements, Last modified: September 2015. http://stats.bis.org/statx/srs/table/d2.
209 “GDP at Current Prices from 2010 to 2020 (in Billions U.S. Dollars),” Statista, Last modified: January 2016. http://www.statista.com/statistics/268750/global-gross-domestic-product-gdp/. JOOSUB 114
Special attention must be accorded to mortgages because they compose the largest assets on the balance sheet of any retail bank. Furthermore, the most volatile derivatives derive their underlying value from mortgages. The exponential growth in derivatives trading is attributed to a lack of regulation and basic ethics. One of the practical uses of a derivative contract is to provide an often-needed hedge against potential losses. Another legitimate, yet controversial way of looking at these contracts is to bet against the default of third party debt, the equivalent of someone taking out a fire insurance policy on their neighbour’s house. The trading of bets completely unrelated to that of an investor’s immediate portfolio creates a plethora of unsavoury motives as well as unlimited access to structured products that should otherwise be limited to only parties involved.
The CDS lost popularity post 2008 because it demonstrated, via the bailout of
AIG as the starkest example, to be a financial ‘weapon of mass destruction’ (WMD).210
Yet the largest asset manager in the world, BlackRock (Assets Under Management
(AUM) approximately USD4.6 trillion),211 has recently started using them again by coupling them with Exchange Traded Fund (ETF) sales.212 Traders are then henceforth incentivised to compile attractive, high-yield, junk bond portfolios. By insuring against their default, a return is guaranteed either way. BlackRock moreover calls for their broader return to financial markets.
210 Michael Snyder, “Warren Buffet: Derivatives Are Still Weapons of Mass Destruction and ‘Are Likely to Cause Big Trouble.’” ETF Daily News, 22 June 2015, accessed 10 February 2016, http://etfdailynews.com/2015/06/22/warren-buffett-derivatives-are-still-weapons-of-mass- destruction-and-are-likely-to-cause-big-trouble/.
211 “Who We Are.” BlackRock. Last modified, January 2016. https://www.blackrock.com/corporate/en-us/about-us.
212 Tracy Alloway, “Why Would Anyone Want to Restart the Credit Default Swaps Market?” Bloomberg, 11 May 2015, accessed 10 February 2016, http://www.bloomberg.com/news/articles/2015-05-11/why-would-anyone-want-to-restart-the- credit-default-swaps-market-. JOOSUB 115
The examination of derivatives in particular, brings with it a word of strong caution to the international community. For the safety of the IMS, they require fastidious regulation, proving thus far to be nearly impossible, or, abolition.
If a reform package is to reduce systematic volatility in the IMS, derivatives have to be dealt with ruthlessly. Even though a reform proposal must still appear attractive to those in the financial community, many of which are still partial to these
WMD’s. Therefore, the derivatives related reforms elaborated upon later will try to also present realistic, positive benefits associated with a strong stance on derivatives.
(6.8) Too Big to Fail – Too Big to Bail
Amongst its goals of increasing transparency and regulating derivatives, the
Dodd-Frank Wall Street Reform and Consumer Protection, was expected to break up the big banks and put an affirmative end to ‘too big to fail.’ Figure 6.h illustrates the degree to which Dodd-Frank failed in one of its biggest promises. As of June 2014, the JOOSUB 116 six largest American commercial banks held 67 percent of the country’s assets.213
Total Assets of U.S Commercial Banks (USD Billions) June 30, 2014 FDIC & SEC 10Q Filings JP Morgan 18% 2,520,336 Rest of U.S commercial Banks JP Morgan 37% Bank of America 5,242,981 Citigroup Bank of America 15% Wells Fargo 2,170,557 Goldman Sachs
Rest of U.S commercial Banks
Goldman Sachs Citigroup 6% Wells Fargo 14% 859,914 10% 1,909,715 1,402,570
Figure 6.h
Despite the obvious antitrust problems, it is unfair to only single out U.S. banks, because the objective of this analysis is to evaluate the global banking practice as a whole. Therefore, Figure 6.i illustrates the larger picture. Twenty of the world’s biggest banks have paid out more than USD235 billion in fines and compensation since 2008.214
The majority of those penalties were for cases of misconduct in the field of mortgages.
It would appear that big banks are not only bigger than ever, but also that they are also here to stay, for now.
213 Alrifai, (2015), 81, op. cit.
214 “Banking Misconduct Bill.” Thomas Reuters, 21 May 2015, accessed 11 October 2015, http://graphics.thomsonreuters.com/15/bankfines/index.html?utm_source=twitter. JOOSUB 117
Total Fines by Bank Thomas Reuters, 21 May, 2015
Bank of Tokyo Fine (US $bilion), 1 ING Socgen StanChart Rabobank Suntrust Goldman Sachs Credit Suisse Morgan Stanley UBS
Bank Deutsche Bank HSBC BNP Paribas Wells Fargo RBS Barclays Citigroup Lloyds JP Morgan Bank of America 0 20 40 60 80 100 Fine (USD Billion)
Figure 6.i
Although as a point of information, The United States is a global financial hegemon. Its open market both shapes and is subject to external global forces215 – but it is only a mild conjecture to suggest that the U.S. generally leads by example. This privileged and public position comes with a good degree of responsibility. Therefore, the idea of leading by example is only illustrated by these American corporations in so far as fines go. Even so, these institutions were only capable of swelling to their present
215 Ravi Jagannathan et al, “What Really Spurred the Great Recession?” (Kellogg School of Management at Northwestern University, 2013).
JOOSUB 118 unhealthy size because of a regulatory climate that allowed it. They effectively create the laws that regulate and govern them.216
The message that governments and regulators have been sending is one that encourages moral hazard. The next time big banks run into trouble, which is not only possible but imminently probable, they can assume that, based on their size and importance in the market, creditors will always be directly or indirectly compensated by government, i.e. the taxpayer. Bailouts aggravate the problem of moral hazard. One such government program is the USD700 billion Troubled Asset Relief Program
(TARP). The bailout, which was intended to stabilize markets and provide liquidity, purchased distressed assets from financial institutions that would have otherwise failed.217
Yet the message it sent has only fuelled distrust in financial institutions. A recent poll conducted by American Express revealed that an increasing number of Americans,
43 percent, would rather keep their savings under their mattresses than in a bank account.218
Consequently, there is a pressing need to tame the growing lack of fiduciary duty and the ensuing moral hazard. However, overconfidence in government assistance may prove to be misplaced. Since the Dodd-Frank Act failed to regulate derivatives and break up these immense institutions, when the next economic hardship comes around,
216 “Monitoring, Regulation and Self-Regulation in the European Banking Sector,” European Central Bank, 21 April 2015, accessed 3 July 2018, https://www.ecb.europa.eu/press/key/date/2015/html/sp150421.en.html
217 “TARP Programs,” U.S. Department of the Treasury, accessed 31 March 2016, https://www.treasury.gov/initiatives/financial-stability/TARP-Programs/Pages/default.aspx.
218 Alap Naik Desai, “43 Percent of Americans Don’t Trust Banks – Here’s why it Makes Sense,” Inquisitr, 12 March 2015, accessed 31 March 2016, http://www.inquisitr.com/1917491/43- percent-americans-dont-trust-banks/.
JOOSUB 119 all the fiat greenbacks in circulation as well as those from QE may not be able to save the global economy from meltdown.
Even JP Morgan Chase Chief Executive Officer (CEO), Jamie Dimon, expressed in November 2009 the need for a ‘resolution authority’ for megabanks.219 This is essentially an expansion of regulatory power to manage orderly liquidation in the event of insolvency and impose losses on creditors, i.e. depositors. Under Title II, Section 204 of the Dodd Frank Act such an authority is created, which apparently massively reduces the chances of a bailout.220 Furthermore, Section 214 even stipulates how taxpayers would be protected in the event of any bailout or liquidation.221 Ironically, however, the loophole is that the resolution does not apply to cross-border banks, like JP Morgan,
Citibank and Bank of America. Therefore, the option of a taxpayer sponsored government bailout remains on the table for the megabanks.
The question must be asked, ‘Why exactly are big banks dangerous?’ Professor of Finance at MIT’s Sloan School, Simon Johnson, offers two general reasons.222 First, the ‘economies of scale’ that big businesses extract from their size is often overrated. It is common that larger firms maintain their market share by ‘bullying’ competition out of the market by employing various barriers to entry such as collusion, predatory pricing, and propaganda. Smaller firms tend to offer customers less homogenized, more efficiently priced products since the need to diversify is vital when there are many
219 Peter Boone and Simon Johnson, “The Future of Banking: Is More Regulation Needed?” Financial Times, 10 April 2011, accessed 18 October, 2015, http://www.ft.com/cms/s/0/e0c55688-63b2- 11e0-bd7f-00144feab49a.html#axzz3ov8jXyU6.
220 H.R. 4173, (2010), 79, op. cit.
221 H.R. 4173, (2010), 143, op. cit.
222 Simon Johnson, “Why, Exactly, Are Big Banks Bad?” The New York Times, 4 March 2010, accessed 11 October 2015, http://economix.blogs.nytimes.com/2010/03/04/why-exactly-are-big-banks- bad/. JOOSUB 120 players in a market. This competitive atmosphere also stabilizes prices without the risk of collusion.
Second, by growing in size and importance, Johnson argues that there are blatant attempts by banks to shape the financial playing field through political influence. The revolving door between Wall Street and Washington is of serious antitrust concern to other small businesses that cannot lobby their interests equally. Moreover, the pursuit of banks to engineer more profit with less competition is changing the appeal of their face to the public. Banking is built on trust and when the institutions that safeguard the capital of a nation engage in the reckless pursuit of profit, anguish will be expressed.
Occupy Wall Street is one such example of a frustrated private sector that has lost faith in its financial institutions.
(6.9) Proprietary Trading
Banks traditionally generate revenues from loans, underwriting, consulting, and providing other services to clients. However, due to its increasingly lucrative nature, proprietary trading expanded in popularity prior to the financial crisis of 2008. This occurs when a bank trades bonds, stocks, currencies, commodities and derivatives from its own capital as opposed to that of the depositors, to make excess returns for itself.
Much like derivatives, this particular practice has deeply diverging opinions in the financial community.
Proprietary trading is dangerous for two reasons. The first is the conflict of interests it creates between a bank and its investment division as well as with its depositors. The proprietary trading desk may quite easily gain client information that it could use to its advantage in an arbitrage strategy, despite the legal separation between commercial and investment activities. It moreover subtracts from the resources that JOOSUB 121 would otherwise be available for servicing customer relations, which is the theoretical priority of a bank. A banking institution’s primary motive is to safeguard deposits.
Objectively, depositors would be naturally discomforted at the prospect that their financial institution is taking high-risk bets for their own gain, using deposits as cushions against potential losses.
The other reason proprietary trading is objectionable is that, in the event of a poor bet, a bank’s exposure could cause insolvency or the need to eat into depositor’s capital as a buffer. Or worse, trading losses could cause widespread market stress and an eventual government bailout. This philosophy illustrates the infamous Wall Street motto, “privatize the profits, and socialize the losses.”
The Glass-Steagall Act, otherwise known as the U.S. Banking Act of 1933 created a firewall between commercial and investment banking. The catalyst for this law was the Great Depression, in which banks were viewed as being too heavily involved in the stock market. In time the Act came to be viewed as overly restrictive by the financial and regulatory community, Bill Clinton himself declared in 1999 that the
“Glass-Steagall law is no longer appropriate.”223 In 1999, President Clinton signed into effect the Gramm-Leach-Bliley Act (GLBA), effectively repealing two of the four key provisions in the Glass-Steagall Act. Investment firms, security firms, commercial banks and insurances brokerages no longer had to be separated, they could act as a combination of those entities. The GLBA also carried with it an expansion of activities a bank could engage in of its own accord.
Fast-forward to the global sentiments after the recession in 2008, the Volcker
Rule is added to the Dodd-Frank Act. Title VI, Section 619 once again restores greater
223 Money, Power and Wall Street, Frontline, Transcript, Part 4, (original release 1999; Washington DC/U.S. Newswire, 1999), Transcripts. JOOSUB 122 power to regulatory bodies in separating the investing and lending activities of banks.224
It took five federal agencies – the FDIC, the Office of the Controller of the Currency
(OCC), the Commodity Futures Trading Commission (CFTC) and the Securities and
Exchange Commission – three years to pass it and it was still only put into effect on
July 22, 2010.225 However, with its 71 pages and additional 892 pages of explanations, the Volcker Rule is still deemed as a ‘light’ version of the Glass-Steagall Act.
Be that as it may, banks can still serve as market makers, they can continue hedging, trading government securities, engaging in insurance activities. They may also offer hedge funds or private equity funds to clients and they can also serve as agents, brokers or custodians. Under the auspices of the Volcker Rule, a bank cannot however, engage in any of these activities if they create a material conflict of interest; expose the institution to high-risk assets or trading strategies; or create instability within the institution or the financial system as a whole.
The Volcker Rule has shown to lack assertiveness, what exactly qualifies as
‘high-risk’ can vary dramatically and a small amount of rhetoric can easily navigate a bank out of a tight spot. Buno Iksil, nicknamed the ‘London Whale,’ accumulated losses for JP Morgan in the region of USD6.2 billion by making market distorting CDS bets.226 Specifically, the culprit instrument may have been a ‘CDX IG 9,’ a CDS index based on the risk of default of major U.S. corporations, otherwise known as a
224 H.R. 4173, (2010), 245, op. cit.
225 Daniel Roberts, “The Volcker Rule Takes Effect Today After Years of Delays.” Fortune, 22 July 2015, accessed 10 February 2016, http://fortune.com/2015/07/22/volcker-rule/.
226 Jef Feeley, “JP Morgan Defeats Investors’ Claims Over London-Whale Losses.” Bloomberg Business, 22 May 2015, accessed 16 October 2015, http://www.bloomberg.com/news/articles/2015-05-21/jpmorgan-directors-don-t-have-to-face- london-whale-loss-claims.
JOOSUB 123
‘derivative of a derivative.’227 The bank was forced to pay around USD1 billion in fines to regulators and admitted violating U.S. laws; yet it avoided a class action lawsuit from investors. Legally, it is hard to clarify what is excessive risk taking versus a regular hedging strategy employed by the bank.
The moral of the story is that banks will pay their fines and walk away. This example is just one instance where the Volcker Rule did not stand in the way, in fact, regulation historically cannot physically bar a bank from participating in misconduct.
Recent overhauls such as the previously mentioned Shelby Bill of May 2015, entails that any financial institutions with consolidated holdings less than USD10 billion are now exempt from the Volcker Rule.228
Therefore, bankers play with fire, knowing that if they burn they can pay a fine and avoid criminal charges, despite the reality of massively increasing fines. By looking at Figure 6.j, it is easy to see that regulatory bodies are breaking under the sheer quantity of white-collar crimes. It would not be farfetched to assume that numerous infractions go under the radar of the over-worked regulatory employees.
227 Katy Burne, “Making Waves Against Whale.” The Wall Street Journal, 10 April 2012, accessed 16 October 2015, http://www.wsj.com/articles/SB10001424052702304587704577336130953863286.
228 Paul Hupiec, “The Shelby Bill Is a Sensible Compromise on Dodd-Frank Reform.” American Banker, 20 May 2015, accessed 10 February 2016, http://www.americanbanker.com/bankthink/the-shelby-bill-is-a-sensible-compromise-on-dodd- frank-reform-1074432-1.html. JOOSUB 124
Total Fines by Type Thomas Reuters, 21 May, 2015
London Whale Fine (US$ billion), 1 Tax Avoidance Libor FX Other US Litigation
Malpractice Sanctions U.K Customer Redress U.S Mortgages
0 20 40 60 80 100 120 140 160 Fine (USD) Billions
Figure 6.j
JOOSUB 125
IMPLICATIONS OF RESEARCH FINDINGS
CHAPTER 7 – REVISION OF MINOR REFORMS
“The moral responsibility has to be defended as long as you live.”229
- J.P. Morgan (1912)
(7.1) ‘Ethical’ Finance Revisited
This chapter will attempt to create an International Financial Code based on the review of various minor reforms and their existing ethical frameworks. It will connect the literature review with the research analysis by selecting the appropriate principles to intercept and remedy the challenges posed in the research analysis. Moreover, the ethical aspect of the international code produced during the course of this chapter will serve to complement and justify the major structural reforms generated in the following chapter.
The research analysis reveals a need for resilient structural changes to the IMS that go above and beyond the conventional understanding of macroprudential reforms.
The nine key antagonists to system-wide risk were isolated and explored in the research analysis; they were money, debt, capital adequacy, CRA’s, accounting principles, shadowing banking, derivatives, proprietary trading and finally the too big to fail phenomenon.
Throughout past attempts in financial reform, whether structural or cyclical, a major ethical framework has consistently failed to accompany the underlying changes.
229 John P. Morgan, “The Justification of Wall Street,” before the Bank and Currency Committee of the House of Representatives (Washington, DC: House Banking Committee, 1912), 5.
JOOSUB 126
Or more accurately, no reform package has ever been presented in unison with an ethical code. Such a support system is relevant by means of its moral justifications for certain structural changes. It would serve to defend against acts of criticism and repeal, of which all reform proposals are the victim.
Two previous examples of sweeping reform Acts are Glass-Steagall of 1933 and
Dodd-Frank of 2010. When the rush of perceived economic prosperity resumed, both acts were eventually defeated respectively with the GLBA of 1999 and the Shelby Bill of 2015. Needless to say, both Glass-Steagall and Dodd-Frank came at a time of desperation and their underlying ethical significance was absolutely critical. Yet, their ethical themes were never codified and set into law. Therefore, as the sting of economic hardship faded and the restlessness for increased profits grew, neither Glass-Steagall nor
Dodd-Frank had a timeless, ethical first line of defence in the face of inevitable attack and overhaul.
The Basel Accords, being ‘soft policy’ recommendations have neither the binding force of the law on their side nor any accompanying ethical justifications. The reforms proposed obviously imply some form or other of positive ethical practices endogenous to financial institutions. Yet, as explained, the lack of any tangible ethical titles or articles provides no additional structurally ethical incentives for adopting the recommendations and no defence against criticism when those in financial circles forget why the Accords were recommended in the first place.
In the review of various minor reforms, the research has revealed some interesting principles that are uniquely suited to tackling the existing nine contributors of systematic risk in the IMS. They are unique in that they could complete a full structural reform package by serving as a financially ethical counterpart. JOOSUB 127
The Islamic finance industry has proven itself to be legitimately less volatile, yet equally profitable to the adjacent conventional financial services industry. The underlying ethical tenets of Sharia compliance have through their soundness given the industry an air of confidence. However, before pursuing the idea of harvesting Sharia complicit finance for ideas that can be incorporated into a financial code, it is necessary to resolve yet one more grave misconception circulating ‘Islamic’ finance.
‘Islamic’ finance is a misnomer. This research finds that there is in fact no such thing as Islamic finance. It is simply ethical finance, the practices of which are built on a system of divine morals. If it were indeed truly ‘Islamic’ in nature then there is no limit to what other professions religious orthodoxy can occupy. We could have Judaic psychology or Catholic microbiology; all claiming to be more ethical than their regular counterparts, the list is anomalous and endless. Scholars of Islamic jurisprudence,
Arabic terminology and consistent references to Sharia law act as no more than a ring fence around what can quite commonly be understood as regular ethical finance. It may be the case that these ‘Islamic’ financial institutions, for whatever reason, are amongst the few pioneering financial firms that have put ethical frameworks into place, but the other misconceptions discussed earlier end up doing the financial institutions in question a disservice.
Given that the analysis in the literature review already identified the principles of Sharia as belonging to the greater Abrahamic body of knowledge and whilst acknowledging the dissidence in the aforementioned assessment, this viewpoint is not to so much to provoke the respected professionals and academics in the realm of Sharia and Islamic finance. It is made more so to simply clarify ethical principles as being able to exist without having to belong to any particular set of religious beliefs. Thus, for the JOOSUB 128 purposes of this research and for the specific purposes of this chapter, certain neutrality can be afforded which is only to be expected in endeavours of academic research.
(7.2) Platform for Ethical Codification
It may be that the proposed international code could aid in bringing reckoning and fairness to a financial system that encourages greed and corruption. For that to happen however, this consensus would need to be transcribed and enforceable by law across each of the 188-member countries of the IMF. The BIS would not necessarily be a sufficient organisation since it only has 60 member central banks globally.230 The perceived assumption that the IMF is a supranational organization, not unique to any particular country, adds to its impartiality – an attractive feature to all of its members.
Moreover, the 188 members of the IMF already pay a subscription fee, receive an SDR quota and follow all of the other obligations found in the code of conduct in the IMF
Articles of Agreement.231
The Articles of Agreement were first brought into force in New Hampshire, 22
July 1944, during the Bretton Woods conference. It has been amended six times since its inception. Given the far-reaching repercussions of the Articles of Agreement, they are a mere 88 pages. Making it more powerful than any sovereign financial agreements yet infinitely more concise and less verbose. The IMF’s General Department enforces the membership obligations and facilitates operations and transactions according to the
Articles of Agreement. The Special Drawing Rights Department deals exclusively with operations and transactions involving the SDR. The SDR and other resources are only
230 “BIS Member Central Banks.” Bank for International Settlements. Last modified January 2016. http://www.bis.org/about/member_cb.htm.
231 International Monetary Fund, Articles of Agreement (Washington, DC: IMF, 2011), 1.
JOOSUB 129 available “under adequate safeguards” and other fiscal factors determined by the
IMF.232
Of all of the privileges, immunities, provisions and other obligations afforded in the current 31 articles, there is no agreed upon ethical international code with tangible macroprudential implications. Consequently, these Articles of Agreement serve as the perfect proposed platform by which to absorb the new International Financial Code supported by this research analysis and formulated during the course of this chapter. As a tentative point for further reference, the most appropriate area inside the Articles of
Agreement would be in or around Article VIII, entitled, General Obligations of
Members.233 Naturally, this would need to be confirmed with the various experts and authorities of the IMF should they decide to consider an international ethical code.
The advantages of using the IMF’s established resources in a reform proposal are that the proposed ethical framework stands to benefit from an incumbent, far- reaching, authoritative and credible platform. Additionally, the Articles of Agreement in question do not suffer from the same afflictions of prolixity, as did previous reform packages. The final and perhaps most important benefit of the IMF as a regulatory platform, is that the articles would have a built-in enforcement mechanism. The Fund is the custodian of the SDR and it is increasing in proliferation amongst members.
Therefore, those who require the IMF’s resources are obliged to make good on their commitment to the code of conduct in its entirety, as outlined in the Articles of
Agreement.
If it does come to pass that the SDR replaces the US dollar as impartial, global reserve asset of choice, the IMF will gain considerably more influence over its
232 International Monetary Fund, (2011), 2, op. cit.
233 International Monetary Fund, (2011), 22, op. cit. JOOSUB 130 members. This is a highly probable scenario given what is already outlined in Section 7 of Article VIII:234
Each member undertakes to collaborate with the Fund and with other members
in order to ensure that the policies of the member with respect to reserve assets
shall be consistent with the objectives of promoting better international
surveillance of international liquidity and making the special drawing right the
principal reserve asset in the international monetary system.
This elevation of authority amongst global governing institutions is not necessarily to be of concern. History has shown that former sweeping reform packages, i.e. the Bank Charter Act of 1844 and the Bretton Woods Agreement of 1944, were initiated most efficiently because of their hegemonic, top-down technique via the
Parliament of the United Kingdom or the Allied powers respectively.
For this International Financial Code to be of particular relevance to the endogenous activities of individual banks, it would be required that the leading officers of these financial institutions confirm their adherence through a personal signature. It could be likewise argued that tellers, brokers, financial advisors, wealth managers, other financial services employees and even regular clients should also give their signature.
However, once a code is set into the law, such an additional requirement is extraneous, since the rule is already implicit in everyday life. It is only necessary for those at the helm of the IMS to go the extra step further and labour through the physical task of signing a document that renders them responsible for leading by example.
234 International Monetary Fund, (2011), 26, op. cit. JOOSUB 131
The argument of this paper is not to prove that the current laws governing finance should rest completely on Abrahamic law. Indeed, the consensus created in the body of this paper extracted only fractional elements of Sharia, concluding that ethical finance is in fact quite secular. It is instead making an appeal to globalization and the recognition that there exists another model, tried, tested and found to be less volatile and more equitable. The aim is to learn how we can underline new reforms with these historic principles so as to sustainably guide our social economic conduct, no matter how seemingly heterodox these principles may be.
It then only remains to discuss the International Financial Code in the context of a broader reform plan, what exactly it would constitute and how it would connect to the research analysis.
(7.3) International Financial Code (IFC)
The following nine principles have been conceived based on simplicity and logic. They are related specifically to the nine root issues, which contribute to system- wide increases in volatility. Although the possible effects that such a drastic consensus could have are definitely broad based. Most importantly, history as well as macroprudential policy, has shown it is the manner and integrity of everyday endogenous transactions in an economy that contributes to aggregate success or failure in a market. They address the needs for individual depositors/consumers, which goes hand in hand with the larger wellbeing of individual institutions.
The IFC, which is a consensus much like the U.S. constitution, is aimed at a wide audience. Indeed, it is aimed at everyone, because the whole world has a stake in an equitable financial system and everyone needs to know his or her corresponding rights. Unlike whitepapers produced for the specific purposes of academic or technical JOOSUB 132 consumption, this universal consensus is comprehensible by the layman, the economist, the politician, the academic or even the philosopher.
It is the first of its kind; it is open to refutation yet needs no defence. Plainly because of a long history of bland, one-sided and ineffective policy that spoke for its proponents each time the global economy suffered from price instability, low growth and low innovation. Stronger medicine is needed by way of ethically structural adjustments.
As a point of disclosure, the views and recommendations expressed in the body of the code are those of the author and should not be reported as representing the views of IMF policy or those of any other regulatory government or non-government organization. Citations in the body of the code serve to indicate the source or influence behind certain recommendations.
INTERNATIONAL FINANCIAL CODE (IFC)
ARTICLE I: Resolution on Money Mechanics
Sec. 101. The function of deposit taking in any company that fits the
description of financial institution shall be organized as follows:
(a) All financial institutions are to hold reserve assets, otherwise known
as reserve money, high powered money (HPM), base money, outside
money, narrow money, vault cash, or central bank money, fully equal
(100 percent) to all demand liabilities on hand.
(b) Demand deposits are therefore fully liquid and convertible into
currency at any time. JOOSUB 133
Sec. 102. The function of lending in any company that fits the description
of financial institutions shall be organized as follows:
(a) Depositors are no longer to serve as a legitimate source of funds for
any financial institution. More specifically, customer’s deposits may
not constitute the numerator of the money multiplier as they normally
do in a typical fractional reserve system. Commercial banking will
now follow a full reserve system.
(b) Therefore, the function of credit creation, ex nihilo, cannot take
place. A financial institution may not loan what it does not have on
its balance sheet. Only the central bank or government institution in
question may create money within the limits of its reserve assets on
hand.
(c) For the purposes of investing, all financial institutions may obtain
legitimate funds (debt) from the following sources: (1) borrow from
the relevant central bank; (2) borrow from another financial
institution; (3) borrow from a non-financial institution; (4) savings
accounts, negotiable order of withdrawal (NOW) accounts, certificate
of deposits (CD) accounts and other timed deposits; (5) sell assets in
the open market with restrictions outlined in Article IV; (6) sell
additional bank equity.
Sec. 103. To facilitate the separation of the deposit taking and lending
functions, the accounting practices for financial institutions will
be organized via two corresponding accounts with the relevant
central bank: a reserve asset account (RAA) and a saving
investment and loan account (SILA). JOOSUB 134
(a) The RAA will hold [unusable] reserve assets fully equal to all
corresponding demand liabilities held in checking accounts and vault
cash at the bank.
i. The corresponding checking accounts may charge customers a
modest deposit fee.
(b) The SILA will hold the banks discretionary funds. These funds will
be reflected as assets with varying maturities derived from sources
outlined in Sec. 102. (c). They may be used to provide commercial
and personal loans in addition to other bank activities.
i. The corresponding saving accounts, as defined in Sec. 102. (c),
will pay customers a share of the profits earned from loans and
other investments made using SILA.
Sec. 104. General core transactions between the RAA and the SILA at the
respective central bank will be conducted in the following
manner:
(a) All electronic and vault cash transactions are reported to the central
bank in question at the end of the business day. The central bank then
undertakes to settle discrepancies between the RAA and SILA of a
financial institution.
(b) When a financial institution issues a loan, the central bank transfers
the amount from the SILA to the RAA. Upon maturity, the repaid
amount is transferred back to the SILA.
(c) When a financial institution makes a payment for any investment
asset, the central bank in question will again debit the SILA account
and credit the RAA account of the recipient’s bank. Revenue from JOOSUB 135
the sale or yield of the investment in question will go into the SILA
of the investing bank.
(d) When a customer deposits a check in his/her checking account it will
be reflected as a deposit liability. The central bank debits the payer
bank’s RAA and credits the payee bank’s RAA.
ARTICLE II: Resolution on Money
Sec. 201. Money, however defined as a medium of exchange and
settlement, a unit of account, a standard of deferred payment or a
store of value, will constitute a representative system that rests on
three pillars, all of which are convertible with one another:
(a) Gold and Silver.235
(b) Special Drawing Rights.236
(c) Hard currency.237
ARTICLE III: Resolution on Orderly Liquidation238 239
Sec. 301. The relevant regulatory body designates a receiver to execute the
liquidation, winding-up and/or break-up of the financial
235 Gold and silver would strictly be reserve assets, redeemable on demand.
236 SDR’s would be electronic in form. They would also represent a value of gold but they would be used on a government and institutional level to settle cross border balances of trade. Gold and silver only need to have physical settlement once a year or once every five years.
237 Hard currency would be any currency currently in circulation, all of which would be redeemable for their respective values of SDR or either gold and silver.
238 H.R. 4173, (2010), 67, op. cit.
239 “Dodd-Frank: Title II – Orderly Liquidation Authority” (Legal Information Institute, Cornell University Law School, 2010). JOOSUB 136
institution in question, regardless of whether or not it has cross-
border activity.
Sec. 302. The purpose of the receiver is to intervene and manage a
liquidation process instead of the government in question.
Therefore, the purpose of the receiver is to invalidate a state
funded bailout under any and all circumstance.
Sec. 303. The receiver is allocated a short-to mid-term timeframe (three to
five years) in which to complete the liquidation.
Sec. 304. The receiver will determine bankruptcy based of two criteria:
(a) The first criterion is likelihood of default. Default is likely when the
receiver determines that the company exhibits behaviour typical to
that of a company prior to declaring bankruptcy. Or, it has incurred
debts that may deplete all or most of its capital, has greater debts than
assets or will likely be unable to pay its debts in the normal course of
business.
(b) The second criterion is an evaluation of the systemic impact of
default on the IMS. Parties taken into consideration are low-income
groups, minorities, ‘below the bread line communities, creditors,
shareholders and counterparties.
Sec. 305. General powers and limits of the receiver.
(a) The receiver shall take on the responsibility of transferring or selling
assets, creating bridge financial organizations to aid in the
assumption of liabilities during the liquidation process.
(b) The receiver shall determine the validity of claims made against the
company and will approve or disapprove thereof accordingly. JOOSUB 137
(c) The receiver may also invalidate or avoid certain prior transfers,
leases, agreements or compensation packages that are determined to
hinder the ability of the receiver to execute the liquidation.
(d) Based on evidence, the receiver may also hold executives,
management or an identified party as directly responsible for
contributing in whole or part towards the liquidation of the company.
If this is the case, the receiver is responsible for collecting evidence
and contacting the relevant authorities.
(e) The receiver may not take an equity interest in the company being
liquidated.
Sec. 306. The receiver shall manage the payment of claims in the following
order: (1) administrative costs; (2) government; (3) wages,
salaries or commissions; (4) contributions to employee benefit
plans; (5) general or senior liability of the company; (6) junior
liabilities; (7) salaries for directors or executives and (8)
obligations to shareholders, members, general partners and other
equity holders.
ARTICLE IV: Resolution on Derivatives
Sec. 401. All contracts, either on an exchange or OTC, deriving their value
from an underlying asset are to seize trading effective
immediately. Such contracts include but are not limited to: (1)
options; (2) futures; (3) forwards; (4) swaps – and all other
variations which fit into one of the aforementioned categories.
Whether for the purposes of speculation or insurance, the creation JOOSUB 138
and trading of these contracts is no longer permitted within the
scope of IMS.
Sec. 402. The relevant regulatory body designates a receiver to facilitate
and monitor the remaining contracts until maturity.
Sec. 404. The appointed receiver reallocates or retires resources that were
previously used to monitor, regulate or facilitate such trades.
ARTICLE V: Resolution on Debt/Equity Products240
Sec. 501. All financial debt instruments marketed and sold by financial
institutions or their qualified representatives, cannot be sold,
loaned, invested or traded as third party debt at a later stage. Only
debt over which there is direct ownership may be traded, invested
or sold by a seller. Specific emphasis is on the prohibition of
securitization for the purpose of resale for; mortgages, auto loans
and student loans.
Sec. 502. The following are a list of securitization options available to
financial institutions that are in harmony with the International
Financial Code.
(a) Various debts may be extended by a creditor against the
collateralization of property or some other asset with residual market
value, with at least 50 percent ownership of the said collateral by the
debtor. The collateral must also be at least equivalent in value to that
of the debt.
240 Zaki Badawi, “Debt Trading and Securitization,” Konsultasi Muamalat, 28 June 2007, accessed 20 March 2016, https://konsultasimuamalat.wordpress.com/2007/06/28/debt-trading-and- securitization/. JOOSUB 139
(b) A creditor may request and accept a guarantee provided from a
private or institutional source, to honour a debt in the event that a
debtor defaults in whole or in part of the said debt. The guarantor is
expected to be in a stronger position to pay than the debtor.
(c) A creditor may not purchase any type of insurance instrument to
protect against the default of a loan. It is the burden of the creditor to
ensure that the financial institution has secured collateral from a
prospective borrower with a satisfactory residual market value.
(d) A creditor may request a clause in a debt contract that under certain
circumstances initiates the replacement of the debt payment by a new
debtor. In the event that the new debtor defaults, the creditor may
demand repayment from the original debtor.
Sec. 503. For any product that is broadly defined as a bond, whether private
or government, trade can only take place at the face value and not
at the market value.
ARTICLE VI: Resolution on Earnings
Sec. 601. For money to earn a yield/return/profit, it must be invested in
something productive, i.e. linked to the real economy. Therefore,
a transaction must reflect a ‘trade’ of sorts.
Sec. 602. Money may not yield more money. The act of ‘trading’ may yield
a return.
(a) All loans extended by financial institutions to private clients for the
purpose of acquiring an asset (tangible or intangible), i.e. homes,
cars, electronics, education or other such assets, require that the bank JOOSUB 140
in question shares in the purchase of the asset first, in whole or in
part, and then sell/lease it back to the client at a surcharge.
(b) All loans extended to commercial clients in the form of a line or
credit or for the purposes of acquiring an asset, require the acting
financial institution to serve as a supervisory partner by taking an
equity stake in the project. A fee/profit may be accrued upon exiting
the said project or investment.
ARTICLE VII: Resolution on Risk
Sec. 701. All yield/return/profit is defined by a PLS framework for all
financial institutions. Thus, no yield/return/profit can be earned
unless risk is incurred and parties in all transactions always
equally share the risk. A creditor/money manager may not
guarantee returns. A creditor can mitigate against the various
risks by employing the following means;241
(a) Equity investment risk. Defined as a decrease in the fair value of an
equity position held by the creditor. This can occur within direct
investments, i.e. home or auto loans or from joint venture projects i.e.
construction financing. The financial institution can reduce equity
risk by performing extensive credit, legal and economic analysis as
well as following other recommendations for debt/equity products
laid out in Sec. 502. (a), (b), (c) and (d).
241 Faleel Jamaldeen, “Risks Unique to Islamic Finance,” For Dummies, accessed 16 March 2016, http://www.dummies.com/how-to/content/risks-unique-to-islamic-finance.html. JOOSUB 141
(b) Displaced commercial risk. Financial institutions are prohibited from
providing synthetically fixed returns on SILA accounts. Therefore,
displaced commercial risk results from profit and loss sharing and is
defined as the risk of losing SILA account holders when a financial
institution has no profits to share. The following measures serve to
reduce this risk; (i) waiving fees or charges for other services; (ii)
creating a profit equalization fund with excess proceeds from
previous years which can be used to supplement periods of lower
earnings; and, finally, (iii) make very clear the advantages and
disadvantages of PLS frameworks to all customers.
(c) Rate of return risk. PLS frameworks provide unpredictable returns.
This risk is defined as a situation by which a financial institution is
unable to provide a rate of return that is at least equal to the market
risk free rate. In this instance it is suggested that the firm in question
follow the measures outlined in the previous section, Sec. 701. (b).
ARTICLE VIII: Resolution on Conflicting Interests
Sec. 801. This section applies to credit rating agencies, defined as any
institution that issues an official assessment (rating) on a debtor’s
ability to pay in general terms or with respect to a particular debt.
Entities qualifying for a rating can range from individuals,
corporations, states or sovereign governments. All CRA entities
will be subject to the following three clauses:
(a) Market structure. The relevant regulatory institution designates a
receiver to work in unison with the relevant competition commission JOOSUB 142
to ensure that the CRA industry does not operate in an oligopoly-like
structure or any other structure that has antitrust implications. The
receiver will be afforded the necessary powers to restructure as
needed.
(b) Fee structure. The CRA in question may not accept payment from
any entity (as defined in Sec. 801.) for which it is directly assessing.
It may only accept fees from a third party “subscriber” or “investor”
for the provision of rating services. Therefore, the ‘issuer pays’
model is prohibited from use.
(c) Client relationship limits. The CRA in question may not continuously
rate an entity in question for more than three consecutive years,
thereafter the entity must select another CRA for its rating and the
previous CRA may not enter a relationship with the entity in question
until four years have elapsed from its last rating. Under no
circumstance may any form of payment, monetary or otherwise, be
exchanged between the CRA and the entity that is the current subject
of a rating.
Sec. 802. Proprietary trading. This activity is rendered largely unworkable
by any financial institutions following the enactment of Article
one, specifically Sec. 101 – Sec. 103, which describes the
separation in deposit taking via RAA’s and savings through
SILA’s.
JOOSUB 143
ARTICLE IX: Resolution on Information Asymmetry
Sec. 901. There is zero information asymmetry between all parties of any
investment or financial contract. All terms of any transaction are
always contractually agreed upon in advance. In addition to the
standard practices of screening and monitoring, collateral and
compensating balances and long-term customer relationships, the
following measures are to be applied by all financial institutions
to reduce the risk of moral hazard and adverse selection:
(a) Incentivized contracts. This is defined by the inclusion of reward
schemes in PLS contracts to promote the cooperation and honesty of
the agent. The principal may also include in the contract a
mechanism that allows it to take a temporary ownership stake. The
principal may also include such covenants that require the agent to
hold reserve or contingency budgets.
(b) Randomized audits. The principal must include a provision inside
any debt/equity contracts with an agreed upon number of random
audits to be conducted at interval until maturity. Other methods that
the principal may use to encourage transparent PLS reporting from
the agent are the option of punitive clauses. Such agreed upon clauses
would be activated in the event that the agent fails to fulfil his/her
contractual obligations.
(c) The use of unbiased credit information. The principal must be
responsible for obtaining and maintaining credit records for all of its
relationships. The principal in question must pay for and acquire up-
to-date credit information from a trustworthy credit bureau. Internal JOOSUB 144
assessments of the agent’s creditworthiness may only begin after a
relationship has been established between the agent and the principal.
(d) Project rationale. A principal is encouraged to look beyond the size
of the collateral as a dominant factor before entering into a
relationship. To encourage entrepreneurial behaviour in the market,
the principal has to stress to the agent the importance of project
viability. Therefore, the principal may demand from the agent a valid
business plan and scope of growth before entering into a relationship.
The articles appear truly excessive in nature, perhaps even absolutely impossible to execute on a global scale. Although upon reflecting on the progressively widening income polarization and the quicksand of global debt caused by previous financial turmoil, the pursuit of economic justice is beyond justified. These articles thus appear vital for the survival of our IMS in the long run.
They will most certainly invoke a plethora of critique and controversy, much like the Dodd-Frank Act.242 That being said, it makes no good sense to speak of international consensual reform in the shape of a conclusive gold standard or SDR or
Chicago Plan, when the structural groundwork is left completely unchanged. That is the purpose of this IFC — to volunteer the hard, structural changes needed that will provoke a long overdue paradigm shift on the world, in a concurrently top-down and bottom-up fashion.
The advantage of implementing these drastic changes now as opposed to after any imminent financial crisis is that a stable financial climate would provide cushioning
242 Jonathan Weisman, “House Passes Legislation to Ease Some Dodd-Frank Financial Rules,” New York Times, 14 January 2015, accessed 3 February 2016, http://www.nytimes.com/2015/01/15/business/house-passes-measure-to-ease-some-dodd- frank-rules.html?_r=0. JOOSUB 145 for, remaining derivatives contracts to be wound up, the orderly liquidation or breaking- up of big banks as well as CRA’s, the implementation of full reserves and the experimentation with PLS retail products.
If the International Financial Code and the ensuing reform were held off until after a fiscal and monetary meltdown, the disadvantages associated with waiting for the music to stop would far outweigh just the mere squabble for financial reform. The size and nature of systematic risk imposed on the global economy by derivatives could easily evaporate global real wealth in an instant. Trading and commerce patterns would be severely interrupted if not halted completely. Cogs do not turn in isolation; this could infer global shortages in the supply of oil, food and clean water. Indeed, it would be daring to construct an international financial code in a politically and economically tumultuous environment.
Yet, the trepidation of global panic and the prospect of an economic tabula rasa may just be the powerful motivators needed to affect drastic change in the industry of money.
By obliging a universal set of principles on bankers and clients alike, with the binding authority of the law, the probability of lasting monetary reform is greatly increased. Although a great deal more rudimentary than the Basel Accords or any whitepapers from other national or international regulatory bodies, these principles can actually promote a healthier financial climate and direct the flow of trade towards responsible activities that benefit society as a whole.
As indicated earlier, these articles draw their inspiration from an existing and respected body of literature.243 They are all entirely Sharia compliant. Although,
243 Alrifai, (2015), 119, op. cit.
JOOSUB 146 interestingly enough, they are not ‘religious’ in any way – their secular disposition aims to advance trade, commerce and profit, whilst preserving fairness and social justice.
The value and timelessness of these articles can only be properly understood and appreciated if the depth of their heritage is brought to light.
Whether Classical, Keynesian, Austrian or otherwise in economic thought, all schools and many more have seen the light of day. The subsequent overemphasis placed on esteemed academic institutions and their PhD offspring has duly rendered a history of volatile fiscal and monetary policy that is based upon the assumptions of expired theory and unpredictable human behaviour.
Perhaps it is time to pull from a deeper set of unchanged, universal principles for the future of our global economy. By referencing principles of Sharia, which is the last link in the chain of Abrahamic law,244 we arguably have the best chance yet to reform more than just our IMS. It is of course naïve to infer that the International Financial
Code will abruptly end all financial and economic dilemmas, but it is a bold step in a long-awaited direction. Its articles provide a foundation for further research into the new idea of ‘financial morality’ as well as equitable financial services that can enable and fortify society’s needs.
Article II of the IFC is of particular importance because it represents perhaps the deepest structural policy changes. It proposes representative money as a replacement to the current fiat and commercial bank money regime. This proposition falls under the category of ‘major reform’ initiative, previously defined as either the SDR the Chicago
Plan or a gold type standard. This drastic overhaul in the constitution of money is further explored and reasoned in the following chapter, before a final discussion
244 Paul Helm, “Philosophy of Religion,” Encyclopædia Britannica, July 2010, http://www.britannica.com/topic/philosophy-of-religion/Philosophy-religion-and-religions.
JOOSUB 147 connects the International Financial Code to the nine areas of systematic importance in the IMS. JOOSUB 148
CHAPTER 8 – REVISION OF MAJOR REFORMS
“Gold is money, and nothing else.”245
- J.P. Morgan (1912)
(8.1) A ‘Gold Standard’ Revisited
The objective of this chapter is to clarify many myths and unanswered questions circulating in academic or professional circles pertaining to a gold standard. The most significant Article in the IFC is Article II, consequently this chapter will furthermore refine the functionality of how a gold standard can work which helps reconcile Article II within the scheme of the greater reform proposal.
Based on the steady chain of events outlines in Figure 3.a, it would appear that we are in orbit of a gold standard; just what kind remains to be seen. This paper is very clear in that it opposes any biased, fiat type systems. History’s best example for a foundation to build upon was none other than the classical gold standard that originated in England after the Bank Charter Act of 1844.246
From the mid 1800’s up until 1914, several countries that had adopted the classical gold standard showcased price stability and real growth. In contrast, the gold exchange standard from 1922 to 1939 failed because central banks did not play by the rules, more notes were in circulation than representative gold. Moreover, the incorrect pricing of gold post-WWI coupled with the stock market crash also contributed to deflationary spiral of the Great Depression. The dollar standard, from 1944 to 1971, explored in detail in chapter one, was christened in Bretton Woods. It lacked political
245 Morgan, (1912), op. cit.
246 “Bank Charter Act 1844,” The National Archives, 2015, http://www.legislation.gov.uk/ukpga/Vict/7-8/32/introduction.
JOOSUB 149 neutrality, it did not account for economic growth and ultimately its mixed success was fully undermined by eventual withdraw from its principal sponsor, the United States.247
Of course, despite being correct in spirit, the frameworks outlined in the Bank
Charter Act of 1844 have been repealed many times over since because they are outdated. Modifications need to be assessed to reflect the current international monetary system.
As recent as February 2016, the ongoing volatility in the U.S. economy has caused Federal Reserve Chairman Janet Yellen to express skepticism over the use of negative interest rates to encourage credit creation and the stimulation of growth.248 Her views are not held in isolation and the shared sentiment amongst other central bankers as well as the OECD, all call for global leaders to take action in the form of urgent policy response.249 Yet, vice chairman of the Asia Pacific at JP Morgan, Jing Ulrich, has in his experience expressed that investors have now lost faith in policy makers and their old toolbox.250
A fire cannot be extinguished by blowing away the smoke and structural reform appears to be outside the arena of central banking. Thus, the actual nature of contemporary money requires questioning. Since the world has no theoretically current need for massive military budgets, it would seem that a fiat regime is no longer a valid framework to fuel the desperately needed innovation and entrepreneurship. The research
247 James Rickards, The Death of Money (London: Penguin Group, 2014), 234.
248 David Stringer, ‘Central Banks are Facing ‘Loss of Faith,’ Gold Veteran Says,” Bloomberg Business, 17 February 2016, accessed 27 March 2016, http://www.bloomberg.com/news/articles/2016-02- 18/gold-veteran-sees-loss-of-faith-in-central-banks-as-prices-soar.
249 OECD. “Elusive Global Growth Outlook Requires Urgent Policy Response.” Last modified February 2016, http://www.oecd.org/economy/elusive-global-growth-outlook-requires-urgent- policy-response.htm.
250 Stringer, (2016), op. cit.
JOOSUB 150 analysis indicates that of the three major reforms evaluated in the literature view, the
SDR and a gold-type-standard of commodity representative money would best define the Money Resolution of Article II in the IFC. This combination may prove to be a superior force in promoting sustained economic prosperity, tackling systematic volatility and ending the threat of bloated, systemic institutions.
Since its inception in 1913, the central bank known as the Federal Reserve has reduced the purchasing power of the dollar by 95 percent.251 Overvalued assets classes, across the entire spectrum of what any portfolio is composed of, are misinterpreted as economic growth. Is long-term price stability, combined with economic growth and reduced market risk, even possible? The answer is quite plainly, yes. History has examples of transparent economies, no less complex than our own, which proved the long-term economic benefits of gold standard type monetary systems.
The silver Roman denarius, first minted in 211 BC retained 100 percent of its original purchasing power for over 200 years before it was slowly debased by Emperor
Augustus and then again by Emperor Nero.252 The result is sovereign gain at the expense of citizens, usually allowing governments to repay their debts with greater ease.
This was essentially Roman QE, not too dissimilar from American QE, designed to dilute colossal debt burdens like the one owed to China of USD1.2 trillion.253 The research has shown that the side effects of wealth confiscation are the disappearance of a middle-class, widening troughs of income disparity as well as increasing economic instability.
251 “CPI Inflation Calculator,” Bureau of Labour Statistics, Last modified: January, 2016. http://www.bls.gov/data/inflation_calculator.htm.
252 Rickards, (2011), 171, op. cit.
253 “How Much U.S. Debt Does China Really Own?” About News, Last modified: 22 May 2015. http://usgovinfo.about.com/od/moneymatters/ss/How-Much-US-Debt-Does-China-Own.htm.
JOOSUB 151
The Byzantine gold solidus had an even more stable record. Ever since the financial reforms of Emperor Anastasias I Dicorus in AD 498, the currency mechanism maintained its purchasing power for over 500 years. Naturally, with this means of exchange, as well as with the former Roman denarius, unemployment was low, cross border trade flourished and the real economic growth that Gallarotti mentions was witnessed. The strong economy of Constantinople was not only the most powerful in the Mediterranean, but scholars indicate that from between the 4th century to the 13th century it was the most powerful in the world.254
However, these are examples of global super currencies, or at least near global.
The way in which economic efficiency was maximized, much like in the European
Union (EU), the Roman Empire as well as the Byzantine Empire could certainly be called Optimal Currency Area’s (OCA).255 They were not global reserve assets, much like the modern gold standard once was, where different currencies were essentially different ways of measuring a weight of gold relative to the US dollar. The classical idea of any form of physical coinage in a gold standard was eventually done away with by developed nations and replaced by representative paper notes. One of the reasons being that physical gold, silver or even copper became cumbersome for daily exchange or the settling of transatlantic balances of trade.
If the international stage is making moves towards the reuse of gold as a future reserve asset, we must confront the genuine challenges that such a system poses, despite its almost fairy tale-like benefits. The research analysis has revealed more questions
254 Warren Treadgold, A History of the Byzantium State and Society (California: Stanford University Press, 1997) 146.
255 Robert Mundell, “A Theory of Optimum Currency Areas,” American Economic Review Vol 51, Issue 4. (1961): 657-665. JOOSUB 152 than answers, serving as potential ammunition for central bankers to use in their sometimes-exaggerated aversion to gold.
(8.2) Monetarists Versus Austrians
Milton Friedman was a highly influential American economist whose work in consumption analysis, stabilization policy and monetary history earned him the 1976
Nobel Memorial Prize in Economic Sciences. Based on his work in monetary policy, he believes that a small and consistent expansion in the money supply over time is the preferred policy for controlled inflation, steady employment and the avoidance of bubbles.256 This is known as ‘Friedman’s k-percent rule.’ A commodity or gold standard suits his monetary policy, with respect to the previous mention of the natural increase in the annual production of gold.
Friedman further expresses his predilection to a pure commodity standard in his book, Capitalism and Freedom:257
If an automatic commodity standard were feasible, it would provide an excellent
solution to the liberal’s (i.e., classic liberal) dilemma: a stable monetary
framework without danger of the irresponsible exercise of monetary powers. If,
for example, an honest-to-goodness gold standard, in which 100 percent of the
money in a country consisted literally of gold, were widely backed by the public
at large, imbued with the mythology of a gold standard and with the belief that it
is immoral and improper for government to interfere with its operation, it would
provide an effective guarantee against governmental tinkering with the currency
256 Brian Doherty, “Best of Both Worlds: An Interview with Milton Friedman,” Reason, 1 June 1995, accessed 1 June 2016, http://reason.com/archives/1995/06/01/best-of-both-worlds.
257 Milton Friedman, Capitalism and Freedom (Chicago, IL: University of Chicago Press, 1962), 41. JOOSUB 153
and against irresponsible monetary action. Under such a standard, any monetary
powers of government would be very minor in scope. But… such an automatic
system has historically never proved feasible.
Sadly, his reservations are based upon the misuse of government powers, which inevitably bring a sound system to its knees. For Example, Freidman explains that in
1930, when banks were closing down and the money supply was declining, the Federal
Reserve was not losing an equivalent amount of gold, yet they “did not play by the rules”258 and they did not hold the money supply steady. As a result, businesses and industry began to fail, which in turn reduced American demand for English imports and thus further fuelled a downward economic spiral.
If there were a return to a gold standard similar to the one once managed by the
Federal Reserve from 1914 onwards, based on experience, economists, politicians and the citizens it serves would not give a vote of confidence.
In observance of monetary frameworks that came after the Great Depression, history does not have too many superior examples. A return to any system with a semblance of the Bretton Woods framework would also be a mistake. Murray Rothbard was an American Economist considered heterodox for his rejection of standard econometrics.259 However, despite his lack of academic journals, his contributions to the
Austrian School of economics were substantial, particularly in the favour of full reserve
258 Free to Choose, Milton Friedman (1980; Orlando, FL: Harcourt, 1980.), Visual.
259 Murray Rothbard, “Praxeology: The Methodology of Austrian Economics” (Essay, Ludwig von Mises Institute, 1976).
JOOSUB 154 banking. In one of his essays, he offered an opinion into the flaws of the Bretton Woods structure:260
The Bretton Woods system was an international dollar standard masquerading as
a “gold standard,” in order to lend the well-deserved prestige of the world’s
oldest and most stable money, gold, to the increasingly inflated and depreciating
dollar. But the post-World War II system was only a grotesque parody of a gold
standard.
Whilst paying homage to the virtues of a classical gold type standard and its stability, Rothbard seemed to infer that history has not done it full justice. In other words, our modern history, post Bretton Woods has never seen a classical gold standard, but rather a government manipulated hybrid. He incorrectly, however, refers to it as a
Keynesian system,261 when the literature has abundantly shown that Harry Dexter
White, the American, was the architect. A true Keynesian system would have seen the implementation of his famously suggested supranational, neutral unit of account, the
‘Bancor’ as a foreign exchange reserve asset. Yet in the Keynesian system, the Bancor would not have been redeemable for gold, unlike in the IFC.
What Rothbard is implying is that there are ineffective gold standards and there are effective gold standards. The most effective would be best served with a side of full- reserve banking, as seen in Article I of the IFC. Despite having a similar viewpoint to the Chicago School, Rothbard differs in that he is more concerned with property rights
260 Murray Rothbard, “The Case for a 100 Percent Gold Standard” (Essay, Ludwig von Mises Institute, 2004), 5.
261 Rothbard, (2004), 5, op. cit.
JOOSUB 155 of an individual and a structure that is more conducive to the gold standard. Whilst being fully aware of the traditional arguments in favour of fractional reserve banking, his logic is understood as follows:262
In my view, issuing promises to pay on demand that are in excess of the number
of goods on hand is simply fraud, and should be so considered by the legal
system. For this means that a bank issues “fake” warehouse receipts –
warehouse receipts, for example for ounces of gold that do not actually exist in
the vaults. This is legalized counterfeiting; this is the creation of money without
the necessity for production, to compete for resources against those who have
produced.
It is hard to refute Rothbard’s observations. Despite his heated rhetoric, he does propose a solution to how banking could look with one hundred percent reserve ratios; he claims those ratios would be best if they were composed of hard gold and silver. Yet, he does not propose ratios for the use of gold and silver, a vital unanswered question.
The obvious implication from his viewpoint is the abolition of fractional reserve banking and hence the complete elimination for the need for the imagination of the
IMF, thus the SDR and the Bancor would be unnecessary.
Deposited money would have the backing of the gold held by the said banking facility. The money would thus be a representative warehouse receipt (like of a bill of lading). Trade balances would be settled without the need of any tools except for the transportation of gold to and from whichever country is in deficit or surplus. In fact, the
262 Rothbard, (2004), 44, op. cit.
JOOSUB 156 only reason why such inventions as the SDR, or the Bancor ever came about was because fiat money, or US dollars, cannot really be redeemed for any hard reserve asset.
Bankers would no doubt lament at the castigation of their industry and the apparent attack on profitability, the echoes of which can already be heard in academic papers.263 If banks were to transform into purely deposit taking institutions, yet still remain profitable, it may be the case that the functions of credit giving and deposit taking are fully separated. Article V of the IFC outlines how banking activities would look in this scenario.
The next phase of evaluation involves viewing the proposals of Article II in light of the Monetarist and Austrian theories. Since these are well-established theories, using them as a point of comparison they serve as a quality control for one of the most fundamental and most criticized concepts, inside the IFC.
(8.3) The Golden SDR
Despite sharing some of the same concepts, this research cannot fully digest the
Austrian schools bitter medicine. The IFC favours the use of the already circulated
SDR, in addition to hard currencies simply because doing so softens the transitions of structural change in the IMS. Additionally, the IFC does not seek do discourage participating members from structural change by insisting on such inconveniences as having to settle international trade balances with hard commodities.
The global economy needs an exchange mechanism that links money to something tangible. This tangible reserve must be completely neutral, therefore disconnected from individual nations.264 A supra-sovereign reserve asset would dissolve
263 Sheila Dow, Guorun Johnson, Alberto Montagnoli, “A Critique of Full Reserve Banking” (Sheffield Economic Research Paper Series, The University of Sheffield, 2015), 9.
264 Xiaochuan, (2009), 2, op. cit. JOOSUB 157 the balance-of-trade issues enunciated by the Triffin dilemma. The SDR fits that description perfectly. However, unlike its current profile defined by the IMF, under the
IFC, the SDR would be backed by gold. All global currencies would qualify for redemption and/or convertibility at a pre-agreed upon fixed rate of exchange. Therefore, this research also has to concede that notwithstanding shared views with the monetarists, floating exchange rates is not one of them.
This particular area, Article II, often IFC has similarities to Rickard’s ‘two- tiered’ system. He describes it as follows:265
“The system would also have to be two-tiered. The top tier would be the SDR,
which would be defined as equal to a specified weight in gold. The second tier
would consist of the individual currencies of the participating nations, such as
the dollar, euro, yen, or pound sterling. Each local currency unit would be
defined as a specified quantity of SDR’s, and SDR’s are defined in gold, by
extension every local currency would be worth a specified weight in gold.
Finally, since every local currency is in fixed relationship to SDR’s and gold,
each currency would also be in a fixed relationship to one another. As an
example, if SDR1.00 = EUR1.00, and SDR1.00 = USD1.50, then EUR1.00 =
USD1.50, and so on.”
The IFC differs from Rickards’ two-tiered system in a few key ways. First, the
IFC suggests that use of the SDR commence in a strictly digital fashion, however, the long-term purview is to eventually sterilize currency differentiation in favour of global
265 Rickards, (2014), 237, op. cit. JOOSUB 158 adoption of the SDR, in both digital and paper form. Starting with digital usage enables all 188 IMF member nations to immediately convert their capital account balances to an
SDR denomination. This is not unrealistic since the system already does away with foreign exchange rate fluctuations, accordingly, in the interests of promoting more fluid global trade, a global currency is the on the horizon.
Second, Rickards is not convinced with the need for 100 percent gold backing of commercial bank deposits.266 Article I of the IFC explains quite clearly the feasibility of full reserve ratios. It provides a new mechanical framework that separates the deposit taking functions and lending functions of financial institutions. The rationale being, to eliminate the issues analysed in chapter six with regards to money, debt and capital adequacy.
By insinuating that a global currency is inevitable for the purposes of maximizing global economic efficiency, the IFC might invite backlash from conspiracy theorists worried about global governments surrendering to a New World Order. From a pragmatists perspective, the IFC is merely embodying such virtues akin to Mundell’s
OCA and Keynes’ original ideas at Bretton Woods. Global commodities such as oil, copper and cotton can be priced via the SDR, removing any previous currency bias.
Moreover, publicly listed corporations would benefit from uniform, global share pricing, a true reflection of a global stock market with a local feel.
(8.4) The Silver Crutch
The system must not allow central bankers to print money without end, yet it must allow for reasonable economic growth. With the supply of money regulated to no
266 Rickards, (2014), 239, op. cit.
JOOSUB 159 more than the growth of the reserve asset, the matter of public debt and fractional- reserve banking is addressed. Therefore, the reserve asset(s) in question must be able to amplify in a controlled and non-inflationary fashion in order to satisfy the reserve needs of member nations. This would address the outstanding issue of money creation.
Under the most basic kind of gold standard, a pure gold standard, paper currency acts like a warehouse receipt redeemable for physical gold.267 It is thus impossible to increase the money supply without increasing mining output or the acquirement of new gold. Thus, under the premise of a gold standard based financial economy, certain areas necessitate further thought because the golden SDR type system suffers from similar fiscal suffocation.
Nevertheless, what does this kind of system actually look and feel like? This is no small question; it is the question and is precisely the reason why economists and politicians simply wave away the debate on gold.268 With respect to our money-printing addiction and current economic outlook, a pure gold standard seems mildly unfeasible – unless it has some help.
The global economy is capable of annual GDP growth analogous to a healthy
3.5 percent, given ideal conditions.269 Annual growth in gold output is only about 1.5 percent and the frequency of reports suggesting peak gold in 2015 is also increasing.270
Which is not encouraging for consistent future expected production.
267 Rickards, (2011), 241, op. cit.
268 Heather Long, “Why Ted Cruz’s Gold Standard Push is a bad Idea,” CNN Money, 28 December 2015, accessed 31 May 2016, http://money.cnn.com/2015/12/28/investing/ted-cruz-gold- standard/.
269 “GDP Growth (annual %),” The World Bank, Last modified: January 2015. http://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG.
270 “’Peak Gold’ in 2015? – Goldman Sachs Research Warns of Peak Gold Production,” Goldcore, Last modified: 30 March 2015. http://www.goldcore.com/us/gold-blog/peak-gold-in-2015-goldman- sachs-research-warns-of-peak-gold-production/.
JOOSUB 160
Two hypothetical solutions exist for the dilemma of limited gold in the face of anticipated annual economic growth. The first involves complementing gold reserves with other asset classes, such as silver, platinum or even real estate. A silver backed currency is more attractive for the purposes of this research because the objective is to fundamentally restore value to money. Silver, strongly advocated for by 19th century economist, Destutt de Tracy,271 is highly liquid and could easily be added or subtracted from gold as reserves based on monetary policy needs and economic growth outlook.
The second theoretical solution is to print money in excess of gold. The first solution is the only solution that can be implemented on the premise of 100 percent reserve ratios and a 100 percent asset backed currency. Although both solutions one and two can be implemented with a money-reserve ratio of less that 100 percent. They therefore both face the same pressing question; what is the minimum percentage of the money supply that must be in gold?272
If, for example, we then take a look at all the existing US dollars in circulation held in the U.S. and abroad, as defined by M2, (see Figure 8.a for definitions), the latest figures from the Federal Reserve put that number at USD12.2 trillion.273 Total U.S. gold reserves will respectively serve as a logical benchmark for pegging the US dollar.
As of February 2015, available data indicates that the disclosed U.S. gold holdings were at 8,133 tons.274 Using basic mathematics and the spot price of gold, USD1,082/oz.275 the expected increase in the dollar value of gold per ounce is shown in Figure 8.b.
271 Terrell, (2016), op. cit.
272 Rickards, (2011), 242, op. cit.
273 Federal Reserve Bank of St. Louis, (2015), op. cit.
274 World Gold Council, World Official Gold Holdings (London: World Gold Council), 1.
275 Gold Spot Price & Charts, JM Bullion, 19 November 2015. http://www.jmbullion.com/charts/gold-price/.
JOOSUB 161
Definition of Money Supply276
M0 Also known as narrow money or base money, it is the smallest most liquid measure of the money supply, coins, paper and other assets that can be rapidly converted into currency.
M1 M1 includes M0 as well as near money, which is savings accounts, MMMF’s and other timed deposits. They are generally less liquid, but still convertible to currency with relative ease.
M2 M2 includes M1 as well as larger, commercial bank time deposits, institutional money market funds and other larger, corporate, liquid assets. Figure 8.a
Implied Price of Gold Relative to U.S. M2 (As of November 2015)
Percentage of Reserves Backed By Gold Implied Price of Gold (USD) per Ounce
U.S. M2 with 10% gold backing USD4,285
U.S. M2 with 20% gold backing USD8,571
U.S. M2 with 50% gold backing USD21,429
U.S. M2 with 100% gold backing USD42,858 Figure 8.b
One hundred percent gold backing of the US dollar would result in an exorbitant
USD42,858 per ounce of gold. Unless of course the U.S. decided to confiscate all private and foreign gold held on its soil. This would raise its holdings to about 17,000 tons, which is more than 50 percent of total global gold reserves, that could dramatically reduce the per ounce price of gold.277 Rather than confiscating foreign gold, which is sure to raise some eyebrows, the US as well as other nations are recommended to supplement the gold backing of the SDR with silver.
276 “Money Supply,” Investopedia, Last modified: January 2015. http://www.investopedia.com/terms/m/moneysupply.asp.
277 Rickards, (2011), 253, op. cit.
JOOSUB 162
This research recognizes that gold is simply too limited in quantity to serve as the sole global reserve. For example, Figure 8.b shows that a reversion to 100 percent gold backing of M2 of the U.S dollar supply would mean a gold price per ounce of
USD42,858. This would not cause inflation, but it would amount to an accurate recognition of the inflation already inherent in the IMS. To soften the spike in prices that a sudden extraordinary devaluation in the US dollar, as well as most other currencies would have, it only makes sense to have a bimetallic standard that includes other commodities, the most appropriate being silver.
Platinum production is scarce, amounting to only 10 percent of annual gold production278. It further has far too much industrial value to be a reserve asset. Silver, on the other hand would be a perfect complement to gold. Despite being considered a precious metal, annual production is approximately 20,000 tons and is derived from a good distribution of mines throughout the world. Most major economies, such as those of the U.S, China, Russia and Mexico already stock, it as a reserve asset.279 Recognizing the importance of precious metals, even the founders of the United States of America inscribed the use of silver, in addition to gold and copper, into the Coinage Act of
1792.280 A dollar was defined as 371.25 grains of silver.
Precious metals are a superior foundation to central bank hard money for the
IMS. The reason being, that they are supplied by the earth in a fashion regulated by mining output which is in turn limited by finite, elemental deposits on the planet. Unlike commercial bank currency, which are zero’s punched into digital ledgers and only
278 U.S. Geological Survey, PLATINUM-GROUP METALS Mineral Commodity Summaries by Patricia Loferski, United States. 2015.
279 U.S. Geological Survey, SILVER Mineral Commodity Summaries by Florence Katrivanos. United States. 2014.
280 The Coinage Act, 1 Statute 246, 1792, http://constitution.org/uslaw/coinage1792.txt.
JOOSUB 163 limited in supply based on the logic of the said central banker, economist, parliament or ruler in charge. Accordingly, precious metals would also be the best medium for a steady annual increase in the money supply, much in the way Friedman’s k-percent rule suggests. In Friedman’s book, A Program for Monetary Stability, he suggests full reserves backed by what he calls ‘high-powered money,’ which is essentially hard currency. On the other hand, this research proposed reserve backing in the form of a bimetallic standard because commercial bank money has not shown to promote the same fiscal discipline as commodity backed money. Yet it shares Friedman’s view that there is no technical reason why there cannot be a smooth and speedy transition to full reserve ratios. He explained that:281
Required reserves could be raised in a sequence of steps at dates specified in
advance culminating in a final raise to 100 percent in, say, two years.
In the event that the gradual increase in reserve ratios reduces the money stock to worrying levels, the central bank in question can simply provide liquidity by means of specialized credit to an economy with large, physical asset purchases in areas of necessity. I.e., Infrastructure projects (healthcare, education, energy, transport). These
‘government sanctioned’ specialized credit facilities would be perfect in that they are linked to the real economy, they add productive value to the economy and the interest repaid on that facility would be generated from the public use of the said infrastructure.
Economists often mistakenly blame monetary failures on a gold or bimetallic standard when they in fact overlook the socially and economically damaging practice of
281 Milton Friedman, A Program for Monetary Stability (New York, NY: Fordham University Press, 1960), 70.
JOOSUB 164 fractional reserve banking. The Great Depression in the chief scapegoat for the berating of a gold type standard. Although the stock market crash of 1929 and the ensuing bank failures and loss of confidence are over looked, even less censure is directed towards the
Smoot-Hawley Tariff Act and the severe drought of 1930 in the Mississippi Valley.282
The bottom line is that of the banks that did not fail, they were unwilling to give blood to the economy in fear that loans would not be repaid.
A well-regulated bimetallic standard is attractive to those who create wealth through hard work and innovation. Those who instead prefer to extort wealth using high interest; inflation and market manipulation eschew the real value invoked by such commodity standards.
Outlining a detailed central banking plan is beyond the scope of this piece of research and could certainly encompass an entire study of its own. That being said, it is important to give central banking operations some attention since major structural reforms cannot possibly avoid a change in central banking functions. Below is a brief list of current, core functions carried out by central banks, additionally, some newly proposed functions that will facilitate the IFC have also been listed:
• Storage of gold and silver.283
• Facilitate the redemption of gold and silver for SDR’s or other hard
currency only up until hard currency is still in circulation, thereafter only
SDR’s will be issued.
• Issuance of SDR notes.
282 Martin Kelly, “Top Five Causes of the Great Depression,” About Education, 30 October 2015, http://americanhistory.about.com/od/greatdepression/tp/greatdepression.htm.
283 Bank for International Settlements, Issues in the Governance of Central Banks (Basel, Switzerland: BIS, 2009), 33.
JOOSUB 165
• Controlling the money supply and price stability using 100 percent
reserves and the K-percent rule as opposed to the Taylor rule as a guide.
• Perform clearinghouse functions with national and international banks
via the RAA and SILA.
• Lender of last resort.284
• Custodian of foreign reserve currencies.285
• Facilitate that annual transfer of hard gold and silver to settle
international trade balance differences.
• Maintain liaison with the IMF through the permanent stationing of IMF
representatives at local central banks.
• Enforce the IMF’s Articles of Agreement, by virtue of which the IFC
will be enforced.
• Regulation and broad market oversight.286
• Collection and publication of data.287
Central banks have shown to have the same stubborn conviction in monetary policy, as does an inebriated man in operating a car. Only when it is too late, do they realize their mistake. Therefore, this research would also stress a very specific mandate for the Federal Reserve and other global central banks. Unlike Friedman and Rothbard, this research does not insinuate that central banks need to be abolished. For the smooth implementation of the IFC, central banks are crucial, however, their discipline is equally
284 BIS, (2009), 31, op. cit.
285 BIS, (2009), 40, op. cit.
286 BIS, (2009), 36, op. cit.
287 BIS, (2009), 31, op. cit. JOOSUB 166 crucial lest they engage in unnecessary monetary and monetary manipulation. Since most of the world’s central banks are IMF members, the IFC would best assimilate globally through the utilization of an incumbent infrastructure. JOOSUB 167
CHAPTER 9 – INTERNATIONAL FINANCIAL CODE
“Most countries fail in the reform and adjustment process precisely because the sectors of the economy that have benefited from… distortions are powerful enough to block any attempt to eliminate those distortions.”288
- Michael Petits, Peking University (2012)
(9.1) Connection to Research Analysis
This chapter will discuss and weigh the relationships between the Articles in the
IFC and the research analysis in chapter six. The aim is to shed light further on the original hypothesis question; can systematic volatility be reduced with structural changes and the implementation of a bimetallic standard?
Figure 9.a below connects the research analysis with the International Financial
Code by illustrating which articles provide the structural economic adjustments needed to address the systematic issues inherent in the IMS. Certainly the impact of the Articles will overlap several research areas, however, issues most potently affected will be explored respectively.
International Financial Code Versus Systematic Issues
Articles
I II III IV V VI VII VIII IX
Money ü ü
Debt ü ü ü ü ü ü
CapitalIssues Adequacy ü Systematic Systematic CRA’s ü
288 Rickards, (2014), 89, op. cit. JOOSUB 168
Accounting ü Principles
Shadow Banking ü ü
Derivatives ü
Proprietary Trading ü
Too big to Fail ü ü Figure 9.a
(9.1.1) Article I
Money – The first Article of the IFC is the most basic and essential measure towards restoring stability to the IFC. It transfers the power of money creation from private banks to government mints, thus abolishing the digital concept of commercial bank money. The availability of limited debt in an economy encourages financial institutions to award credit to only the most innovative enterprises. Having the k-percent rule as a recommended guide for the annual money supply enables the relevant central bank to ensure that economic growth does not wildly fluctuate, whilst intervening in a minimum fashion. “K” would be a constant that determines the fixed annual growth of money based on the production of gold and possibly also silver.
Debt – These changes should ensure that the velocity of money is restored to healthier levels seen between 1960 and 1970. Access to cheap credit has not pushed innovation and productivity, nor has it helped employment, as was discussed in chapter six. At an Asia Society meeting in April 2016, in expressing concern over the global economic slowdown, George Soros made comments likening Chinese debt-fuelled growth to recent American growth.289
289 Simone Foxman, “Here’s How George Soros’s Latest Predictions Have Played Out.” Bloomberg, 9 June 2016, accessed 9 June 2016, http://www.bloomberg.com/news/articles/2016-06-09/here-s- how-george-soros-s-latest-predictions-have-played-out. JOOSUB 169
Most of the money that banks are supplying is needed to keep bad debts and
loss-making enterprises alive.
When companies are not allowed to fail when they reach inefficiency, corruption or redundancy, they stunt the natural evolution of an economy. Keeping them on life support finance funnels the labour force and other resources away from new innovation and production.
Not only do these practices create uncertainty and risk in the banking sector but they produce inflation. Full reserves add downward pressure on inflation, but they also promote more prudent financial decisions amongst individuals, corporations and governments. A party that takes on debt has to create productive value in order to make the profit and loss sharing scheme work. That is why the previously mentioned special government sanctioned credit is primarily for advancing large infrastructure projects.
Capital Adequacy – In segregating the deposit taking function and loan issuance through dedicated SILA accounts, moral hazard has been greatly reduced. It is now only when a depositor consents to being a source of funds by transferring equity into a SILA account that they agree to share in the profits and losses of the bank.
Moreover, the dubious practice of risk weighting assets to derive a CAR is also no longer necessary as a result of full reserve banking. With the existing system, banks are incentivized to down play the riskiness of their investments so that they can lower reserve requirements and thus increase their potential for higher profits. Under the IFC, a banks SILA portfolio should still be risk weighted, but for accountability to investors and auditors. Ultimately, the bank in question is incentivized to actually produce JOOSUB 170 profitable investments with appropriate risk or a customer can open a SILA account with a competing institution.
Accounting Principles – Under the IFC, all 188 IMF member nations would have to unify their accounting regimes under the same standards on a stricter timeline as opposed to the laxity with which changes are currently taking place.
The transparency of a financial institution’s balance sheet usually gives a viewer an insight into the health of the firm. However, in having SILA accounts now reflect the assets section of a financial institution, a viewer will get a macroeconomic slice illustrating the health of the greater economy. The greater transparency is afforded because the assets section of a balance sheet bares the PLS deals the bank is taking part in. The respective value added to the economy is reflected in the liabilities and owner’s equity section, where the RAA shows outstanding demand deposits and the retained earnings sections reveals the profits or losses accrued from the banks investment decisions.
Under the PLS scheme, all financial assets are marked-to-market. This has to be the case because, for example, home repayments to a bank from a client have to reflect the current market value of the home. Despite the accounting ramifications, this system is especially advantageous for investments that have a bubble-like quality or are prone to cyclicality. When the market is down, purchasing clients do not need to fear debt deflation. When the market is high, banks do not need to fear contracts that have sealed them off from higher profits.
That being said, because of the nature of SILA accounts and increased accountability of investable capital, the IFC does not promote a loose credit policy that has historically contributed to asset bubbles. JOOSUB 171
Regarding the debt-equity tax bias that exists in current corporate tax structures,
Article I changes the nature of financing into equity regardless of whether it’s a bank loan or bond issuance. To further facilitate and incentivise this equity financing, tax accounting can henceforth grant a reduction for a return on equity, as was previously the case from interest payments.290 This proposal reduces the incentive for corporations to grow on the back of debt, which previously acted as a tax shield. There was a similar proposal by the US Treasury in 1992,291 designed to reduce the debt-equity corporate tax distortions. Such a system, sometimes known as an Allowance for Corporate Equity
(ACE), was implemented in Belgium in 2006 and it has since been shown to have reduced leverage of non-financial firms by between two and seven percent.
Shadow banking – As it stands, the USD70 trillion shadow-banking sector does not fall under any formal regulation, which is the primary cause for concern amongst financial watchdogs.292
Of all the major risks presented by this murky sector, the IFC plays a general role in governing the nature of their transactions through legal frameworks. However, since shadow banks are not officially classified as traditional banks with the regulations that deposit taking comes with, it may be that they are only partially susceptible to IMF regulation. According to analysts at the IMF, these hedge funds, MMMF’s and investment banks contribute to 30 percent of the systemic risk in the U.S. and 7 percent in the UK and 13 percent in the Eurozone respectively. The final concern, bank runs,
290 Fatica, (2012), 12, op. cit.
291 The Department of the Treasury, Integration of the Individual and Corporate Tax Systems, Taxing Business Income Once (Washington, DC: 1992), vii.
292 Angela Monaghan, “Shadow Banking System a Growing Risk to Financial Stability.” The Guardian, 1 October 2014, accessed 12 June 2016, https://www.theguardian.com/business/2014/oct/01/shadow-banking-system-risk-financial- stability-imf.
JOOSUB 172 can be safely relegated to the dark ages of banking. Full reserves provide 100 percent redemption of demand liabilities during rain, snow or sunshine.
Proprietary trading – No amount of regulatory jargon can discourage banks from proprietary trading.293 However, by separating deposits and lending activities, as is the case in Sec. 101 – Sec. 103, the increased transparency and isolation of core activities will leave no room for non-value adding behaviour. Nevertheless, trading from a SILA account with the consent of the account holder and under the mutual understanding of shared profits and losses is acceptable.
(9.1.2) Article II
Money and debt – Article II is the cornerstone of the IFC. It deals with the root of monetary reform. Chapter 6 explained how the Taylor Rule as a guide for monetary policy was inappropriate. Even more discouraging for a healthy economy was the fact that financial institutions, with completely different objectives to central banks, were the ones with the power of credit creation.
The IFC promotes an industrial and thriving economy and it allows for participation from the public through SILA accounts. Central banks have at their disposal OMO and the k-percent rule to alter the money supply given indicators like; employment, prices and consumer confidence.
The standard formula for GDP is as follows:
GDP = C + G + I + (X – M) (2)
293 Matt Levine, “Banks Can Still Have Fun Prop Trading in Rates.” Bloomberg, 25 June 2014, accessed 13 June 2016, https://www.bloomberg.com/view/articles/2014-06-25/banks-can-still- have-fun-prop-trading-in-rates.
JOOSUB 173
‘C’ is a function of private consumption, which largely includes home and auto purchases, which makes up roughly 60 percent of GDP.294 ‘G’ is government expenditure, which is procured from tax revenue, making up 17 percent of GDP depending on which country is being reviewed. ‘I’ represents investments, private and public, local and international, which makes up roughly 17 percent of GDP. ‘X – M’ is the net difference between exports and imports. This number varies from negative to positive depending on whether an economy is export or import driven They add up to the resulting GDP, which is supposed to provide a measure of a country’s performance and corresponding standard of living.295
The reasons why we see public debt grow exponentially without the remotest correlation to GDP is because the expenditure associated with consumption really has nothing to do with productive economic growth. It’s simply interest payments, the beneficiaries of which are financial institutions. Under Article II, the greatest component of GDP, consumption, is no longer debt fuelled. Further benefits associated with curtailing debt burdens are continued in other Articles.
(9.1.3) Article III
Too big to fail – Article III is straightforward in that it provides an orderly resolution, which gives the IFC pre-emptive powers to dismantle firms that have a high likelihood of default and a high systemic relevance.
However, breaking-up big firms with a systemic balance sheet, cannot put an end to poor practices, it can only make the effects of poor practices less destabilizing.
294 “Components of GDP: Explanation, Formula and Chart,” About Money, Last modified: 31 March 2016. http://useconomy.about.com/od/grossdomesticproduct/f/GDP_Components.htm.
295 “Gross Domestic Product – GDP,” Investopedia, last modified: January 2016. http://www.investopedia.com/terms/g/gdp.asp?layout=infini&v=5E&orig=1&adtest=5E.
JOOSUB 174
The savings and loans crises of the 1980’s and 1990’s are an example of small banks behaving badly, too.296 Therefore Article III acts as an insurance policy in the event that the IMF or other regulatory agency cannot fully or only partially enforces the remaining
Articles.
One reality that cannot be sidestepped is that large banks have the disposable capital needed to make large investments in technology, which in turn offers their customers massive conveniences. Such examples are mobile banking through smart phones and ATM’s (Automated Teller Machine) that offer almost as many services as does a branch office.
However, being big and technologically savvy comes with one serious word of caution. Big banks are popular targets for cyber criminals. Their sprawling and diverse business interests means that by the time authorities are aware of a hack much has already been damaged. The attack on JP Morgan in 2015 was the largest hacking case uncovered in history.297 The criminals used 75 shell companies; 30 false passports, multiple offshore accounts and managed to be convicted of 23 counts of fraud and other illegal activities. Having a big cyber security budget is no guaranteed defence either.
Despite having spent USD250 million on cyber security, JP Morgan’s efforts were thwarted and the personal information of 83 million customers was compromised. For security reasons, members of the public still do not know the full extent of the breach.
Smaller banks can still benefit from the technology that bigger banks use, since it is becoming more widely available at more competitive pricing. Yet they will never
296 Kenneth J. Robinson, “Savings and Loan Crises,” Federal Reserve History, 22 November 2013, http://www.federalreservehistory.org/Events/DetailView/42.
297 Liz Moyer, “Prosecutors Announce More Charges in Hacking of JP Morgan Case.” New York Times, 10 November 2015, accessed 16 June 2016, http://www.nytimes.com/2015/11/11/business/dealbook/prosecutors-announce-more-charges- in-jpmorgan-cyberattack.html?_r=0.
JOOSUB 175 suffer from the same complexity of processes and critical systems are scarcely outsourced. Therefore, in the event of a hack, breaches in security can quickly be identified and remedied. Moreover, their geographical footprint is smaller, thus reducing their inherent cyber risk.298 The smaller footprint also means that negative effects are localised to the region in which the bank operates, rather than national or international consequences.
Article III proposes breaking up large financial institutions for more reasons than systemic relevance or solvency. The perceived future risks of banking are in fact manifested in the present.
(9.1.4) Article IV
Shadow banking and derivatives – Article IV is another component of the IFC that is direct in its confrontation and thus plain in its desire for structural modifications.
The two main risks pointed out in the research analysis on shadowing banking were that they did not have access to the FDIC type safety nets and they were further causing disintermediation in the financial industry by operating as a ‘maverick’ amongst conventionally regulated banks. These risks were discussed as having limited systemic relevance, albeit the current FDIC deposit insurance system cannot cover even a minor bank run. However, it gives the confidence needed to deter such panic-induced public behaviour. Article I of the IFC, proposing full reserve ratios and separation of deposit and lending taking functions, is what truly puts an end to bank runs.
The other unique aspects of shadow banks are not by any means deplorable.
They cater for a niche in the market by way of supplying much needed short to midterm
298 Priya Anand, “Why Your Money May be Safer With Small Banks.” Market Watch, 2 July 2015, accessed 16 June 2016, http://www.marketwatch.com/story/why-your-money-may-be-safer-with- small-banks-2015-07-02.
JOOSUB 176 liquidity and funding in the form of tri-party repurchase agreements, securitization and asset backed commercial paper conduits (ABCP).299
However, Article IV is directed towards the dismantling of the derivatives market, which is particularly relevant for the shadow banking industry because more than half of all global derivatives contracts in interest rates (fixed-income) and FX trading now take place via shadow banks.300 Furthermore, 83 percent of all derivatives contracts are OTC, as in completely off any regulatory radar.301
Former investment bank Bear Stearns is a classic example of how the gluttonous appetite for exotic derivatives can lead to an explosion in speculation. By year-end
2007, Bear Stearns had USD395 billion in assets on its balance sheet propped up by
USD11.1 billion in equity, equating to a leverage ratio of 36 to 1. Moreover, the notional value of their derivative contracts totaled USD13.4 trillion.302 A CDO went hand-in-hand with a CDS contract, which altogether further fuelled and still does incentivise the packaging and securitization of ‘tranches’ of ‘junk’ debt. Shadow banks can in effect become like a one-stop shop for prescription drugs, sold without a prescription, over-the-counter and with a high likelihood of harm as opposed to help.
Removing the ability to create contracts which reward the proliferation of additional risk is a structural limit imposed on the financial services industry for the proximate objective of macroprudential reform.
299 Tobias Adrian, Adam B. Ashcraft, “Shadow Banking Regulation” (Staff Report, Federal Reserve Bank of New York, 2012), 10.
300 Patrick Jenkins, “Derivatives Move From Banks Into the Shadows.” Financial Times, 11 September 2013, accessed 19 June 2016, https://next.ft.com/content/b98ec11c-1b07-11e3-a605- 00144feab7de.
301 Deutsche Börse Group, The Global Derivatives Market An Introduction (Frankfurt: Deutsche Börse AG, 2008), 7.
302 William Ryback, “Bear Stearns” (Case Study, Toronto Centre, 2013), 5.
JOOSUB 177
One additional consideration is for non-financial-counterparties (NFC), which includes firms and governments, currently making up a relatively small proportion of outstanding derivative contracts. However, their use of derivatives, which includes hedging prices fluctuations in FX and commodity markets, is completely justifiable.303
Consequently, Articles I and II of the IFC render the concept of floating exchange rates a thing of the past and ensure that future commodities are priced with the standardized
SDR. The research concedes that this is a bold reform suggestion, since monetary sovereignty is essentially forgone for a single, global, supranational unit of exchange.
(9.1.5) Article V
Debt – The main function of Article V is to target and eliminate the creation of securitized junk debt. As previously mentioned in the effects of Article IV, investment banks, hedge funds, MMMF’s and other SIV’s thrive off the securitization of third-party debt. The pooling of various credit risks to form tranches as part of a synthetic CDO, only further spurs on the creation of the notorious CDS derivative.
Understandably so, securitization per se cannot be singled out as the primary cause of the Great Recession in 2008. As far back as 1993, 65.3 percent of the total U.S. mortgage volume was securitized. In 2006 that number was not significantly higher, as the total volume was 67.7 percent.304 However, the jump in the usage of the concurrent
CDS is worthy of note. According to some of the earliest data on CDS issuances from the International Swaps and Derivatives Association (ISDA), in 2001, total outstanding
303 Orcun Kaya, Svenja Freiss, “Who Are the End-Users in the OTC Derivatives Market?” (Research, Deutsche Bank, 2015), 2.
304 Scott Hirst, “Did Securitization Cause the Mortgage Crisis?” Harvard Law School Forum on Corporate Governance and Financial Regulation, 19 October 2011, https://corpgov.law.harvard.edu/2011/10/19/did-securitization-cause-the-mortgage-crisis/.
JOOSUB 178
CDS contracts were at USD918.87 billion. Just before the recession started in 2007, that number was at USD62.1 trillion.305 The way in which the CDS market exploded is because of the allowance for ‘naked’ contracts. Naked contracts are those sold to buyers who do not hold the loan instrument and have no direct insurable interest in the loan. As a result, a seller of CDS insurance can be liable for multiple claims that could easily drive it into bankruptcy.
Therefore, in knowing about the additional ways to monetize a simple mortgage, it is hard to make the argument that regular commercial banks always extend credit on the basis of liquidity, credit risk and the beneficent desire to put a roof over someone’s head. If this were untrue, in how many documented instances does a bank actually disclose to its client that the mortgage it was about to extend was going to be packaged and sold to another financial institution?
To clarify yet further, the restrictions on securitization outlined in Article V are designed to create more prudent lending practices. For example, Sec. 502. (c) does not allow for the insurance of a loan (CDS) in the event of default. It thus obliges banks to procure sound collateral. Equally enough, by asking borrowers to have at least 50 percent ownership of the collateral they put up, they are encouraged to not leverage themselves beyond their means.
(9.1.6) Article VI
Debt – Article VI puts forward changes on the manner in which financial institutions can henceforth attain their earnings, more specifically it elucidates the PLS ideology and the idea of real economy transactions. Profit for all rather than a few. The reason for these changes is because the current economic framework no longer
305 ISDA Market Survey, ISDA, Last modified: 2010. JOOSUB 179 cultivates the same rate of innovation it once did.306 Looking at the allocation of debt in a country like the U.S., justifies the assumption on which the changes in Article VI rest.
However, there are fundamentally two kinds of debt and they must be scrutinized in order to understand why resources are flowing away from value adding activities. There is government debt and private sector debt. Government debt can be defined as the bonds issued by a government in excess of their deficit shortfall to finance government expenditure, for example, treasury securities. Private sector debt can be defined as the cumulative liabilities held by NFC’s. For example, this would include growing interest burdens on regular loans for homes or cars as well as other debt securities. Figure 9.b illustrates the proportion of government spending in mandatory, discretionary and interest expense for year-end, 2015.
FY2015 Mandatory and Discretionary Spending and Interest on Federal Debt (USD billions) OMB National Priorities Project
229.10
Mandatory Spending 1,110.00 Discretionary Spending
2,450.00 Interest on Federal Debt
Figure 9.b
306 “The Great Innovation Debate.” The Economist, 12 January 2013, accessed 23 June 2016, http://www.economist.com/news/leaders/21569393-fears-innovation-slowing-are-exaggerated- governments-need-help-it-along-great. JOOSUB 180
The vast majority of public expenditure in the U.S. goes into mandatory and discretionary expenses. Figure 9.c further dissects those two categories by taking a look at the cross-section of total mandatory and discretionary expenditure.
Total Federal Spending FY2015: USD3.8 trillion OMB National Priorities Project 50.22 61.48 44.85 Social Security, unemployment and labour 84.99 29.81 102.26 Medicare and health 135.70 Military 160.63
Interest on debt 1,280.00 229.15 Veterans benefits
Food and agriculture 609.30 Education
Transportation 1,050.00
Housing and community
International affairs
Figure 9.c
Social Security, unemployment benefits, Medicare and other health support systems make up the lion’s share of the total federal budget. Military expenditure is debatable in terms of the public being the net beneficiaries of its innovation. Investing in areas like education, transportation, science and energy and the environment are undoubtedly portions of an economy that contribute towards improving the infrastructure and the general quality of life.307 Most important is that a dollar spent
307 Nathan Rosenberg, “Innovation and Economic Growth” (Organization for Economic Co- operation and Development, 2004), 1. JOOSUB 181 today on technological and productive innovation has additional ‘units’ of benefit for many generations to come, as opposed to only benefitting the consumption of one generation.
The data shows that government, in this instance the United States, is not always disposed towards promoting value creation for generations to come. Most expenditure is prioritized towards keeping other areas of the economy afloat, but is far from producing actual job creation and growth.
Article VI lays out restrictions on lending which can in turn help commercial banks and the private sector contribute to the flow of resources needed to keep innovation and real growth alive. It changes the way daily dealings are made, turning regular interest bearing loans into trade-like transactions that require banks to take a vested interest in a prosperous economy. Under the reform proposal of profit and loss sharing, debt is never perpetual and bankers become partners seeking to ensure the successful repayment of any loan. Parties harbouring the means to create positive effective change in the infrastructure, education, environment and scientific hemisphere of a society will be able to approach banks knowing that they are motivated to create a successful partnership. The creation of specialized government facilities for the said infrastructure projects could also act as syndicate vehicles for private investors to benefit from the future returns.
(9.1.7) Article VII
Debt – Article VII addresses the non-uniform distribution of risk in a typical loan. It is closely connected with the previous Article in its stressing the importance of a profit and loss framework for the effective removal of moral hazard and restoration of financial justice. JOOSUB 182
In a typical loan, there are multiple risks born by the creditor. However, the creditor also has multiple paths of recourse at his/her disposal that a borrower simply does not have. In the event of default or late payments to a bank in the current IMS, at best, the borrower has a deteriorated credit score. At worst, the borrower stands to lose everything including his reputation, which affects his/her future ability to attain credit.
This is no exaggeration.
By asking banks to take a stake in their loan portfolio and behave as partners, they share some of the risks that their clients incur. Article VII recognizes that the PLS framework changes the nature of the risk landscape and thus put forward ways that a financial institution can manage their altered risk profile.
(9.1.8) Article VIII
Credit rating agencies – Chapter six covered in detail the havoc that can be the result of inaccurate ratings caused by a deep and unaddressed conflict of interests.
Current reform efforts in the U.S. targeting Nationally Recognized Statistical Rating
Organizations (NRSRO) can be summarized by a comment made in 2014 by SEC
Chair, Mary Jo White:308
This expansive package of reforms will strengthen the overall quality of credit
ratings, enhance the transparency of credit rating agencies and increase their
accountability. Today’s reforms will help protect investors and markets against a
repeat of the conduct and practices that were central to the financial crisis.
308 “SEC Adopts Credit Rating Agency Reform Rules,” U.S. Securities and Exchange Commission, Last modified: 27 August 2014, https://www.sec.gov/News/PressRelease/Detail/PressRelease/1370542776658
JOOSUB 183
Despite the efforts to build on the Credit Rating Agency Reform Act of 2006,309 the SEC has still failed to explicitly address the key areas of conflicting interest, that being, the issuer pays model.
Article VIII puts blatant restrictions on the fee structure and relationships that
CRA’s are allowed to maintain with their clients. Moreover, the IFC also recognizes that CRA’s are oligopolistic institutions that consequently distort equality in the market structure and suffocate the growth of smaller agencies. These antitrust implications reflect as laxity in rigor within the three dominant market players who hold in their ranks massive power.310 However, antitrust law does not apply to oligopolies that are not in express collusion.
Accordingly, Sec.801.(a) gives the instruction for a regulatory body to designate a receiver that can break up the industry in a manner similarly suggested by Jeffrey
Manns, Associate Professor at the George Washington University Law School. To tackle the issue of market structure, Manns would suggest that, in this instance, the designated receiver imposes a limitation on the major CRA’s that only allows them to rate certain categories of debt. By barring the oligopolies from rating a variety of firms, governments and debts, Manns assumes that they would be forced to spin off parts of their businesses into freestanding companies.311
309 Public Law 109-291, Credit Rating Agency Reform Act of 2006, 109th Congress, 120 STAT. 1327, 2006
310 Aditya Chakabortty, “Time to Take Control of the Credit Rating Agencies,” The Guardian, 16 January 2012, accessed 27 June 2016, https://www.theguardian.com/commentisfree/2012/jan/16/time-control-credit-ratings-agencies.
311 Jeffrey Manns, “Break Up the Rating Agency Oligopoly,” American Banker, 4 September 2013, accessed 1 July 2016, http://www.americanbanker.com/bankthink/break-up-the-rating-agency- oligopoly-1061752-1.html. JOOSUB 184
However, these changes to market structure do not completely eradicate the risk of these newer smaller firms swallowing up the entire market share of ratings pertaining to the debt of firms, governments or bonds that they specialize in.
Changes in the market structure of the CRA industry can help kick-start the much-needed competition in a stagnant arena. Yet, it is the more invasive changes to the fee structure and client relationships that can really improve accountability and accuracy. Thus far and much to the anxiety of some, regulatory agencies have shied away from such assertiveness which casts a shadow on their powers and foresight. This is especially worrying when these institutions have more supremacy in dictating the rise and fall of corporations and governments than the Pope had during the Coronation of the Holy Roman Empire.312
Interestingly enough, presidential hopeful Bernie Sanders went so far as to say that under his administration, all CRA’s would be turned into non-profits.313 Whilst this research does not completely rule out such a potent remedy for conflicting interests, the
IFC has opted instead to maintain the profitability in the industry yet level the playing field so as to encourage new entrants into the market. Profitable CRA’s can and should be those that have an unblemished reputation for accuracy and autonomy.
(9.1.9) Article IX
Debt – Articles V, VI and VII put heavy emphasis on trying to change regular debt contracts into real economy linked, equity trade-like contracts. Article VII
312 Patrick Kingsley, “How Credit Rating Agencies Rule the World.” The Guardian, 15 February 2012, accessed 7 July 2016, https://www.theguardian.com/business/2012/feb/15/credit-ratings- agencies-moodys
313 Ben Walsh, “Why Bernie Sanders Wants to Make Credit Rating Agencies into Nonprofits.” The Huffington Post, 1 July 2016, accessed 7 July 2016, http://www.huffingtonpost.com/entry/bernie- sanders-credit-rating-agencies_us_568d2826e4b0a2b6fb6e0bff.
JOOSUB 185 acknowledges that these reformed contracts can expose financial institutions as well as borrowers to new risks. As a result, Article IX, the last Article in the IFC, stresses the multiple ways in which information symmetry can be increased between banks and their clients, or principals and agents.
Incentivized covenants, randomized audits, obtaining thorough credit information and vetted business plans are crucial to prevent against the age-old problems of moral hazard and adverse selection. Yet these recommendations are expensive and do not build too much on existing precautions taken by banks.314
Moreover, they could effectively hurt some classes of borrowers in that the new banking structure reallocates funds away from them.
Mindful of these circumstances, the IFC still insists on Article IX. The reason is that most banks don’t always go through the extra effort and expense of administering the aforementioned precautions. Instead, they rationalize the imposition of higher interest charges on higher credit risk customers as an easier, short-term solution to protecting against moral hazard and adverse selection.315
This poor business practice has many issues. First it directly contradicts the idea of KYC, thus banks do not end up collecting the valuable store of information on their customers that they should for the purposes of a transparent and healthy future relationship. Second, higher ‘blanket interest rates’ are levied on customers whose credit risk might actually afford them much more favourable fees.
The higher cost of profiling customers leads to more efficient and profitable business. It is also in the interests of all financial institutions to share client information amongst them, if it is so requested. One customer often has relationships with multiple
314 Giovanni Dell’ Ariccia, “Asymmetric Information and the Market Structure of the Banking Industry” (Research Department, International Monetary Fund, 1998), 5.
315 Ariccia, (1998), 7, op. cit. JOOSUB 186 banks for multiple reasons. Therefore, different banks will observe limited patterns of behaviour based on their unique relationships respectively. To reduce the cost of KYC as well as enhance its effectiveness, banks could benefit greatly from sharing the data they gather based on the recommendations in Article IX.
The effect on net private debt of reducing information asymmetry is that banks are less likely to make poorly calculated loan decisions. In essence, it helps keep the balance sheet lean. JOOSUB 187
CHAPTER 10 – FUTURE LANDSCAPE
“If you think in terms of a year, plant a seed; if in terms of ten years, plant trees; if in terms of a hundred years, teach the people.”316
- Confucius, (551 – 479 BC)
(10.1) The Faustian Prospect
This chapter will examine the relevance of financial intuitions, which are a microcosm in and of themselves, yet in so many ways prove to be the denominator in our civilizations path. Therefore, it is this penultimate chapter that almost serves to justify this research effort and all other research efforts that pertain to trying to salvage some sense of justice in our monetary system.
Going through the effort to dissect our monetary system is tedious and certainly at times, overwhelming when something as light as the price of gold, has behind it academic journals and variegated literature beyond count.
When contemplating the origins of mankind and their advancement as a species through the millennia, on this planet, a financial reform plan seems like an infinitesimal spec in the grand scheme of cosmic design. Yet, as thinking beings that are a product of cosmic design, humans are constantly evolving through time by various means. Finance enables trade and commerce, which in turn satisfies our basics needs. The financial economy also acts as a catalyst to fuel our more advanced needs. These advanced needs, such as the industrial age, the atomic age, the information age and the space age all had
316 “The Most Famous Confucius Quotes,” Ranker, January 2016. http://www.ranker.com/list/a-list- of-famous-confucius-quotes/reference?var=8&utm_expid=16418821- 248.s3Qj9REsSuWZ6BH5rpLFCQ.7&utm_referrer=http%3A%2F%2Fwww.ranker.com%2Flist%2F a-list-of-famous-confucius-quotes%2Freference.
JOOSUB 188 to happen in order to continue servicing the most demanding dilemma we face as a species – the effective allocation of finite resources for a thus far infinite demand.
Survival of the fittest does not only depend on natural selection, the savvy intercession of financial institutions enabled these massive leaps forward in our development, allowing mankind to leave its signature on the space-time fabric. Use of Google’s
Ngram Viewer, which references the vast number of books that Google has scanned from public libraries, will even show that the use of the word ‘finance’ has multiplied dramatically through the period earmarking our greatest technological advances (1700 –
2016).317
Sadly, the poor intercession of financial institutions can have equally devastating circumstances – grossly ineffective allocation of resources. The results are apparent today; unemployment, corruption, bureaucracy, sluggish innovation and the list of maladies goes on. However, that being said, declining civilizations are nothing new.
The German historian and philosopher, Oswald Spengler, predicted the specific decline of Western, or as he calls it, Faustian civilization nearly 100 years ago. He uses the reference of Goethe’s tragic figure, Faust, to insinuate a parallel between the Western world and Faust’s desire for power. Just as Faust sold his soul to the devil, the West sold theirs out of love for pure and limitless infinity.318
Despite a mild distaste in academia for predictive social theories,319 Spengler’s ideas are far from untrue. In preparing his model, he studied eight of the worlds High
317 “Google Books Ngram Viewer,” Google, Last modified: 13 July 2016. https://books.google.com/ngrams/graph?content=finance&case_insensitive=on&year_start=1700 &year_end=2008&corpus=15&smoothing=1&share=&direct_url=t4%3B%2Cfinance%3B%2Cc0%3 B%2Cs0%3B%3Bfinance%3B%2Cc0%3B%3BFinance%3B%2Cc0%3B%3BFINANCE%3B%2Cc0.
318 Ricardo Duchesne, “Oswald Spengler and the Faustian soul of the West: Part 1,” Council of European Canadians, 4 September 2014, http://www.eurocanadian.ca/2014/09/oswald-spengler- and-faustian-soul-of-west-part1.html.
319 Aaron Lester, “The Problem with Predictions.” Harvard Gazette, 25 April 2015, accessed 13 July 2016, http://news.harvard.edu/gazette/story/2013/04/the-problem-with-predictions/. JOOSUB 189
Cultures: Babylonian, Egyptian, Indic, Sinic, Mesoamerican (Mayan/Aztec), Classical
(Greek/Roman), Magian and finally, Faustian. He divided these civilizations into four cycles, or as he called them ‘seasons’ – spring, summer, autumn and winter. The cultural emancipation of a period is known as the ‘organic’ spring and summer of the civilization. This is when society is inspired by a wave of art, philosophy, science and religion. Autumn and winter are when a society becomes ‘inorganic.’ It only stands on the shoulders of its previous cultural developments, which slowly fades away as civilization congeals, urbanises and loses inspiration.320
What are Spengler’s thoughts on the direction of our civilization? His conclusions can be understood by what he writes in his book, The Decline of the West, a monumental achievement which covers the fields of money, history, art, science, philosophy and theology:321
The future of the West is not limitless tending upwards and onwards for all
time… but a single phenomenon of history.
He further explains that other signals marking the end of the Western summer and decline of our cultural achievements were circa 1800. According to him, it was at this point that modern writers had exhausted the possibilities of true philosophy and music as well, had peaked in its eloquence with Wilhelm Richard Wagner. Towards the end of volume two, Spengler is cited by historians as being increasingly pessimistic about the decay of modern society. They moreover find contradiction in his
320 Oswald Spengler, The Decline of the West (Oxford: Oxford University Press, 1923, 1928, 1932, 1991), 31.
321 Spengler, (1991), 30, op. cit.
JOOSUB 190 metaphysical and historical objectives.322 However, despite the manner of his predications, which were undoubtedly influenced by Germany’s milieu in WWI,
Spengler writes with a degree of astuteness.
Spengler’s ideas are important to this research for two reasons. First, the similitude drawn between seasonal change and societal progression sheds light on the pressing need to insulate and preserve innovation and justice when the icicles of winter set in. Some of these icicles can be portrayed as the nine topics of concern mentioned in chapter six. His research can be used to learn from the repetitive patterns of history, which may be impossible to change, but by resisting complacency it is possible to turn a decline into a transition. Whatever the fate of the Faustian era, adequate financial reform cannot be sidestepped because its fate and the fate of the IMS are deeply interwoven.
Second, they illustrate that the current Faustian worldview, which is frequently and naively assumed to last forever will come to an end. We do still see traces today of some of the eight High Cultures that came before us, although their dominance and influence is fractional compared to what it used to be. Some of those civilizations dwindled and others came to an abrupt and probably violent end. Their fates are a reminder that nothing is permanent. The onus on this research is not to save the day and prevent the inevitable tides of change. Rather, the IFC is offering the financial economy a means of keeping warm during what may be a harsh winter. Interestingly enough,
Spengler proposed a type of reform to the legal system. Finally, civilization will move in the direction of its said destiny, irrespective of our choices. We can contribute positively, negatively, or have no impact at all.
322 Annie Pfeifer, “Oswald Spengler,” The Modernism Lab at Yale University, Last modified: 15 January 2010. https://modernism.research.yale.edu/wiki/index.php/Oswald_Spengler. JOOSUB 191
(10.2) What is the Role of Banks?
Going back to the first principles, the standard definition for the function of banks is that they are intermediaries. They connect people who do not needs funds to people who do. They are a means of storage for people who would rather not hide their money under their mattresses. They are the enablers of growth and trade. They are in many ways, the lifeblood of the IMS.
Yet the truest test of these first principles is for example, whether a household with surplus funds and a company or government needing to borrow can be connected at a low cost and in a way that makes both parties better off.323 If historically this has been happening without too much fuss, then why has banking, an industry with such a heavy responsibility to the wellbeing of the world, become such a poorly respected profession?
British economist John Kay argues that finance has come to be seen as an end in itself, an opinion not too different from Aristotle’s thoughts on the objective of money.324 Kay points out that the economy exists to serve Wall Street and other financial hubs rather than the other way around. If you applied that paradigm to electricity generation, for instance, the incongruity would be evident because electricity is not generated for its own sake. Does something resembling social value get generated when an investment bank transacts with an asset manager? If the answer is no and there is no net benefit to society, then Kay would surmise that the costs of intermediation are in effect, a tax on everybody else.
323 Clive Crook, “The Future of Finance.” Bloomberg, 22 November 2015, accessed 18 July 2016, https://www.bloomberg.com/view/articles/2015-11-22/the-future-of-finance.
324 Crook, (2015), op. cit. JOOSUB 192
Financial institutions have become larger and more complex than they need to be in order to satisfy their first principle, efficiently. The Oxford University fellow is also explaining that this has happened because the finance industry has been collecting implicit subsidies, notably in the form of a government’s promise to defend and bailout an ailing institution. This is one form of ‘encouragement’ that has allowed banks to develop complex and non-value adding activities.
Banking has for too long been a fast and loose industry. It is qualitatively similar in prestige to law, medicine, engineering and education, in that it is indispensable to civilization and, without it, society would not be able to function. The current paradox, however, is shown in Figure 10.a. As a profession, it does not demand the respect it ought to. It should be shoulder to shoulder with teachers, police officers, scientists and doctors, but it is not. Since when did the custodians of national wealth and the facilitators of commerce fall from grace?
Forbes Business - America's Most Prestigious Professions The Harris Poll, 2014
Teacher Architect Priest/Minister/Clergy Police Officer Engineer Nurse
Profession Scientest Firefighter Military Officer Doctor
0% 20% 40% 60% 80% 100% Percentage of Adults Polled Find the Following Occupations Most Prestigious
Figure 10.a JOOSUB 193
This industry has been a magnet for the type of talent that reflects its corrupted core principles. Unfortunately, recent reforms have been faint in addressing the lucid and darker aspects of human nature, which left unchecked in a highly competitive industry, can succumb to greed, injustice and moral hazard.
In 2014 and 2015 The Wall Street Journal conducted a survey amongst investors and asked them which companies they respected the most.325 Answers were ranked from 1 to a 100. Many systematically significant banks ranked in the lower 50 of respected companies and in the bottom 10, sat Bank of America (94), Citigroup (95) and
UBS (97). In the top 10, Wells Fargo (7) was held in similar opinion to Apple (1), Walt
Disney (2) and Berkshire Hathaway (3). These opinions come from investors, not average citizens who don’t always have a clear understanding of financial institutions. It might be hard to compete with companies that gave the world the iPhone and Disney
Land, but surely banks ought to be ranked better.
Banking is built on trust. It is necessary to ask what the role of these institutions is because this thesis suggests that over time, we have resigned ourselves to looking at banks as any other large businesses that contribute to the economic ecosystem. The reality is very different; banks hold a special place in society.
Safeguarding deposits is another of their most basic functions. This thesis argues that without a doubt, these institutions are the single most essential catalysts behind growing trade and commerce and expanding global development. In other words, the financial health of our global economy determines the rate at which our civilization advances in the most intriguing fields, like nanotechnology, artificial intelligence, biochemistry, space exploration and much more. Although above and beyond all the
325 “The Worlds Most Respected Companied: A Complete Ranking.” The Wall Street Journal, 2015/15, accessed 18 July 2016, http://online.wsj.com/public/resources/documents/RespectTable.pdf. JOOSUB 194 fanciful creations of the human mind, the need for financial stability is now more essential than ever. The future of mankind has never looked so promising and so bleak at the same time. It is necessary to observe and understand the challenges we face as a species if we are to fully appreciate the need for a strong financial system that can deliver us through our impending challenges.
Rather than constantly creating new provisions that act like patchwork over existing provisions, the IFC suggests a more logical approach that is to implement a once off fixed set of rules based on a new financial and monetary system that tackles the flaws of the existing regime.
Thus, the job of the regulator is transformed. They would be enforcing those rules rather than continuously having to create new ones. As it is, the existing role of other regulators has them spread too thin and enforcing regulation rather than producing regulation would create a much more focused and effective operation.
Assuming that the IMF takes the lead on the IFC by incorporating it into its existing Articles of Agreement, there may be room for calibration depending on how member nations and institutions respond. We do not live in a perfect world and it is brash to assume that modifications will not be necessary, even in a masterful system.
That being said, acceptance or rejection boils down to public opinion.
(10.3) The End is Nigh
Former governor of the Bank of England, Lord Mervyn King, has recently warned that another financial crisis is “certain” and will come sooner rather than later.
His term as governor was from 2003-2013, he thus witnessed the brunt of the recession. JOOSUB 195
His comments are interesting because they transcend the typical attack on regulators and bankers:326
Without reform of the financial system, another crisis is certain, and the failure
... to tackle the disequilibrium in the world economy makes it likely that it will
come sooner rather than later… The crisis was a failure of a system, and the
ideas that underpinned it, not of individual policymakers or bankers,
incompetent and greedy though some of them undoubtedly were.
Although Lord King is painted as being at the heart of the GBP500 billion- government rescue package for British banks,327 he was in fact averse to rescuing
Northern Rock Bank and came under fierce criticism for his disbelief in saving banks from the consequences of their own mistakes.328
He thus correctly indicates that the world witnessed a failure of the banking system brought about by poor market oversight and a complete lack of structural reforms. Yet, it is hard to trust his certainty about the imminence of the next financial crisis. Sentiment throughout this research has also been on the side of urgency, but the
326 Mervyn King, “Mervyn King: New Financial Crisis is ‘certain’ Without Reform of Banks.” The Guardian, 28 February 2016, accessed 17 July 2016, https://www.theguardian.com/business/2016/feb/28/mervyn-king-new-financial-crisis-is- certain-without-reform-of-banks.
327 Angela Monaghan, “Financial Crisis: Bank of England Cuts Interest Rates in Global Effort.” The Telegraph, 8 October 2008, accessed 17 July 2016, http://www.telegraph.co.uk/finance/financialcrisis/3160735/Financial-Crisis-Bank-of-England- cuts-interest-rates-in-global-effort.html.
328 Isabel Oakeshott, “Brown Said World’s Worst Financial Crisis Would Last Only Six Months.” The Sunday Times, 4 September 2011, accessed 22 July 2016, http://www.thesundaytimes.co.uk/sto/news/Politics/article768648.ece.
JOOSUB 196 truth is, global markets have shown alarming elasticity towards bizarre central banking policy.
The Federal Reserve currently has USD4.2 trillion on its balance sheet. Prior to
2008 that number was USD800 billion. Half of this debt has foreign owners.329
Accordingly some economists, such as Philadelphia Federal Reserve president, Charles
Plosser, are worried about the central role that the Federal Reserve has in the global economy.330 The US dollar is still the pricing mechanism for ‘gold, oil and guns’ and perhaps that is the only reason it manages to tread deep water.
Yet it has been losing its purchasing power for decades and other countries have been expressing their frustration for decades and still, no dollar apocalypse. Thus, it is hard to make the argument, as Lord King does, that collapse is nigh. The truth is that it is impossible to predict because of a complex variety of factors. Some members of the
‘gold camp’ deduce that the oversupply of US dollars will lead global markets to perceive the inadequacy of fiat currencies once and for all. More extreme investors think that the demise of the US dollar will take the whole American economy with it.331
Yet North America’s economy is not entirely a picture of doom and gloom. It has been making considerable moves to strengthen itself, regardless of the statistics. It has become a major player in the world of energy, with local fracking now fuelling half of all U.S. oil output.332 An imported commodity that was largely responsible for the
329 Department of the Treasury. Major Foreign Holders of Treasury Securities. Washington, DC. 2016. http://ticdata.treasury.gov/Publish/mfh.txt.
330 Ted Kemp, “The US dollar to Reign Supreme for Decades to Come.” CNBC, 24 April 2014, accessed 17 July 2016, http://www.cnbc.com/2014/04/24/future-of-money-what-currencies-will- look-like-in-25-years.html.
331 Kemp, (2016), op. cit.
332 Matt Egan, “Oil Milestone: Fracking Fuels Half of U.S. Output.” CNN Money, 24 March 2016, accessed 17 July 2016, http://money.cnn.com/2016/03/24/investing/fracking-shale-oil-boom/.
JOOSUB 197 massive US budget deficit. Moreover, as a percentage share of global totals, the United
States currently holds more than 60 percent of global venture capital investments, more than 50 percent of global assets under management and generates about 50 percent of global investment banking revenue.333 These significant strengths are all dollar denominated revenues that continue to fuel the demand for US dollars, which contributes to why 60 percent of all FX reserve are still held in US dollars.
Currency analyst at DailyFX in New York City, Christopher Vecchio, gives the no-nonsense perspective from investors who do not see a crisis on the horizon:334
People have been saying the dollar is going to collapse for 20 years, but it is
emotional rhetoric.
Nevertheless, Vecchio’s outlook concisely represents what is known in behavioural finance as the gambler’s fallacy.335 In other words, he is failing to recognise that past events are independent of the future. This point of view is like a case study worth stressing simply because so many investors are of the same state of mind.
Finance behaviouralist’s would also say that Vecchio is anchoring. In that he and investors like him have a tendency to attach their thoughts to a reference point.
They then refuse to waver in opinion regardless of new information: the SDR is gaining
333 “The Shake-up of America’s Strengths.” The Economist, 1 October 2015, accessed 20 July 2016, http://www.economist.com/blogs/graphicdetail/2015/10/daily-chart.
334 Kemp, (2016), op. cit.
335 Trevir Nath, “Investing Basics: What is the Efficient Market Hypothesis, and what are its Shortcomings?” Nasdaq, 15 October 2015, accessed 17 July 2016, http://www.nasdaq.com/article/investing-basics-what-is-the-efficient-market-hypothesis-and- what-are-its-shortcomings-cm530860.
JOOSUB 198 international attention, there is a covert rush for gold, fiat systems don’t last more than one lifetime and a replacement for the Bretton Woods system is in fact overdue.
These forms of cognitive dissonance, over confidence, rationalization and in some instances, out right denial will always exist. They continued to persist even through the 72 hours of Bear Stearns’ collapse on 16 March 2008.336 Albeit, this research intentionally juxtaposes Lord King’s views with those of the Nasdaq currency strategist, Vecchio, the objective being to nurture caution and attention to the facts.
History indicates how empires, which at the time seemed would last forever suffered from financial crises. The Romans and Byzantines had their resources drained by droughts and wars. They thus had to levy higher taxes on the populace to maintain their dominance over their vast empires. The subsequent increasing gap between the ostentatiously wealthy and the destitute consequently led to their demise.
More recent examples are the Great Depression (1929), the oil crises (1973,
1979), the Latin American debt crisis (1980’s), Black Monday (1987), the U.S. saving and loan crisis (1989-1991), the Japanese asset bubble collapse (1990’s), the Mexican peso crisis (1994), the Asian financial crisis (1997), the Russian ruble crisis (1998), the
Dot-com bubble (2000) and finally the Great Recession (2008).337 This list could be called abridged, in that it does not include several ‘mini’ crises, such as the Russian ruble crisis (2014)338 and the Swiss franc euro peg abolition (2015).339
336 Kate Kelly, “Inside the fall of Bear Stearns.” The Wall Street Journal, 9 May 2009, accessed 20 July 2016, http://www.wsj.com/articles/SB124182740622102431.
337 Alrifai, (2015), 48, op. cit.
338 Ksenia Galouchko, Vladimir Kuznetsov, “Ruble Tumbles to Record as Oil Slump Hinders Russia’s Recover.” Bloomberg, 20 January 2016, accessed 20 July 2016, http://www.bloomberg.com/news/articles/2016-01-20/ruble-trades-at-record-low-as-oil-impact- worse-than-sanctions.
339 Charles Purdy, “The Swiss Euro Peg Abolishment and its Consequences.” Forbes, 16 January 2015, accessed 20 July 2016, http://www.forbes.com/sites/charlespurdy/2015/01/16/the-swiss- euro-peg-abolishment-and-its-consequences/#4daf05248d67. JOOSUB 199
The boom and bust cycles reveal that crises are occurring with less time in- between them and are also increasing in severity. Measures taken to mitigate or address one calamity often sow the seeds for the next.
This is precisely why this chapter assesses the future landscape whilst cross- referencing different opinions to historical events. The reform objectives have not been unrealistic in suggesting that the IFC could simply eradicate the phenomenon of crises, but they have suggested changes to the underlying fabric of the IMS that were not done after any of the previous crises mentioned. Looking forward, the hope then, is to create a less volatile environment conducive to equitable and sustainable financial activity.
(10.4) IMF in the Spotlight
Early in 2016 the IMF launched a study with the objectives of understanding the current challenges facing the IMS as well as laying out a future basis for reform.
Siddharth Tiwari, Director of the IMF’s Policy, Strategy and Review Department, identified the Funds position as ‘central’ in the IMS whilst discussing the scope of the study.
Tiwari’s optimistic and confident tone expressed that many people see the Fund as the IMS’s ‘guardian.’ They have also recently increased their lending firepower to
USD1 trillion as well as increase the SDR quotas for member countries. In diagnosing the major concerns on the horizon for the IMS, Tiwari highlights three broad areas.340
340 IMF Survey, “IMF Landscape Debate on Future of International Monetary System.” IMF Survey Magazine: Policy, 17 March 2016, accessed 22 July 2016, http://www.imf.org/external/pubs/ft/survey/so/2016/POL031716A.htm?utm_campaign=sniply& utm_medium=sniply&utm_source=sniply. JOOSUB 200
1. There are a series of post-crisis (2008), structural shifts taking place in the global
economy that raises volatility. Furthermore, compressed demand in advanced
economies has increasingly contributed to current account imbalances.
2. The central role of one or two major global reserve currencies means that
positive economic developments in one economy can work to restrict
developments in another.
3. As economies become increasingly connected, ‘episodes of capital flow
volatility are becoming a permanent part of the landscape.’
His other remarks on the survey draw attention to the more mainstream areas in finance currently propagating popular media. These remarks include a mention of
China’s anticipated rebalancing, which is likely to have spillover effects. He mentions the opening of Middle Eastern economies as commodity prices hit historical lows. He mentions how the varied monetary conditions in the world’s major economies, the
United States, Europe and Japan, will all continue to contribute to global market volatility. The study reveals the connectedness of the global economy by indicating that for decades many countries have had highly correlated financial cycles with the U.S., this has been even more so since the financial crisis of 2008.341
Finally, he draws attention to the concept of globalization, which in some fresh instances has come under threat.342 He personifies the idea of globalization as the process whereby living standards in emerging markets and developing countries would, over time, converge to those of more advanced economies. Yet Tiwari’s concerns of
341 International Monetary Fund, Strengthening the International Monetary System – A Stocktaking (Washington, DC: IMF, 2016), 15.
342 Katy Barnato, “After Trump Speech, WTO Chief Says Protectionist Language Poses Risk to Trade.” CNBC, 22 July 2016, accessed 23 July 2016, http://www.cnbc.com/2016/07/22/after- trump-speech-wto-chief-says-protectionist-language-poses-risks-to-trade.htm. l JOOSUB 201 increasing economic protectionism are not the only threat to the future of this dream. As the British economist John Kay points out, when finance becomes an end in and of itself, its unnecessary complexity hinders the net benefits of economic activity to society.
Tiwari concludes his comments on the study by realistically explaining what the future challenges are, unique to the IMF. Without the full approval and participation by member nations, it will be unrealistic for the IMF to continue to assume a central position in the IMS:
So while the Fund is at the centre of the international monetary system, we are
part of a larger system with central banks and other standard-setting agencies.
Our role is to provide analysis and a shared understanding, but the onus will lie
on the membership to take reform forward… Having countries agree on a
framework to make capital flows safer will be among the issues that will require
a lot of work. But this is essential and goes hand in hand with a stronger global
financial safety net (GFSN).
It is important to contrast how the IMF sees itself versus how the public sees the
IMF. The Fund’s intervention is at times seen as controversial. Its sizable loan packages come with an equally sizable set of conditions. Some of the more recent financing agreements were in 1997 during the East Asian Crisis, Africa during the past three decades, Ireland in 2010, Portugal in 2011 and Greece in 2015.343 The tax reforms, pension reforms, spending cuts, crackdown on corruption and other austerity measures
343 Kirsty MacKenzie, “Facing the Future at the International Monetary Fund.” 24 July 2015, accessed 24 July 2016, http://www.bbc.com/news/business-33652399.
JOOSUB 202 are bitter medicine for countries that are not used to having their sovereignty compromised for a foreign concept of financial discipline.
However, changes to an economic regiment are on occasion a good way from preventing rust from setting in, despite being onerous. Unhealthy patterns can be broken and young ideas can receive attention. Hence, the bitter medicine would be all the more tolerable except for the fact that the IMF is still seen as preserving some outdated rules and generally lacking in transparency. Professor at Harvard University and former chief economist at the IMF, Kenneth Rogoff, said that:344
The number one issue for the IMF is to dispense with the ridiculous requirement
that the managing director be a European, and that the World Bank be run by an
American. It’s an incredible anachronism.
Rules such as these as well as the apparent deficiency of merit based leadership means that the Fund may have a difficult time sustaining the respect it needs as an indispensable institution. Professor Ngaire Woods, expert on global governance and dean of the Blavatnik School of Government, Oxford University, elucidates this reality further:345
I think the risk to the IMF is irrelevance and marginalization. Emerging
economies are using other things – anything but rely on the IMF. If you’re
sitting in Zambia, Brazil or China, it looks like an organization that’s still run by
the USA and Europe.
344 MacKenzie, (2015), op. cit.
345 MacKenzie, (2015), op. cit.
JOOSUB 203
Already the playing field of developmental mega-banks is witnessing some new rival activity. The Brics Bank, otherwise known as the New Development Bank (NDB), whose members include Brazil, Russia, India, China and South Africa, is a new institution tasked with the objectives of fostering economic cooperation and development in emerging market economies.346
There is also the Asian Infrastructure Investment Bank (AIIB), whose initiative was led by China in 2013, but whose 57 representatives is a roll call of the world’s most powerful economies.347 The United Kingdom, France, Germany, Switzerland, India,
Russia, the Gulf States and more, the strongly felt absence of the United States clearly indicates their feelings towards such initiatives.
Unlike these two aforementioned banks, which were created with tangible purpose in the developing and developed world, the IMF has had to pivot since its creation in 1944. In fact, since the demise of the Bretton Woods Agreement in 1971 and thus with no IMS framework to oversee, the IMF wandered for many years without an identity. It has only recently started describing itself as a ‘crisis lending’ institution.348
Even so, it was thought that its newfound purpose would only be for the benefit of nations classed as ‘developing.’
All that being said, the IMF is of course aware of the isolated instances of political stigma towards it. Its response to the sometimes-negative public perception is
346 “New Development Bank BRICS,” NDB, Last modified: January 2016. http://ndbbrics.org/.
347 “What is the Asian Infrastructure Investment Bank?” AIIB, Last modified: January 2016. http://euweb.aiib.org/html/aboutus/AIIB/?show=0.
348 “IMF Crisis Lending.” 30 September 2016, accessed 1 March 2017, http://www.imf.org/About/Factsheets/Sheets/2016/08/01/18/48/Crisis-Lending?pdf=1.
JOOSUB 204 neutral and by no means apologetic.349 In the previously discussed study, with commentary by Tiwari, the IMF points out that whilst some delay seeking assistance from the Fund and see it as distasteful; others see it as a signal of strength. The example of Mexico is given. Furthermore, it defends its tough ‘conditionality’ by mitigating any
‘risk of moral hazard associated with Fund lending by providing incentives for good policies.’
Moreover, neither do the NDB nor the AIIM have something in their arsenal akin to the SDR. As a replacement reserve asset, the volatility of individual currencies still makes the SDR the substitute of choice. The membership standings of these new banks are significant, but nowhere close to the 188 members of the IMF. They may create pockets of economic development and trade, but the IMF’s muscle has advanced to the point where transit fees for the Suez Canal are priced in SDR’s.350 Pricing the facilitation of trade between the Atlantic and Indian Oceans is something that affects the whole world. It means that the SDR is globally recognized as a unifying unit of account that reduces currency volatility in trade.
Nonetheless, the most encouraging comments come from the IMF’s first Deputy
Managing Director, David Lipton. Lipton is confident that the next selection for head of the Fund will be strictly merit based, with potential candidates from around the world.
These are comments that some critics of the Fund have waiting for almost 20 years to hear.351 Additionally, at the June 2016 Bretton Woods Committee annual meeting,
Lipton stressed the need for unity by suggesting cooperation between the Fund and the
349 Strengthening the International Monetary System, (2016), 29, op. cit.
350 “Maiden Voyage.” The Economist, 5 December 2015, accessed 26 July 2016, http://www.economist.com/news/business-and-finance/21679341-its-new-status-might-make- weaker-yuan-chinese-renminbi-joins-imfs.
351 MacKenzie, (2015), op. cit.
JOOSUB 205
AIIB, whose formation he welcomed. Rather than seeing new development banks as rivals, the IMF’s tone is very much in favour of their creation especially if they help in furthering the overall objective of re-evaluating the IMS based on its current needs.
Lipton stresses the following:352
Re-examination of the international monetary system can help here. We can re-
assess how macroprudential and capital flow measures can provide protection.
We can ask how to promote growth supporting equity flows. And how we can
better promote technology transfer… And we can create a better global financial
safety net, including through IMF coordination with regional financing
arrangements, and possibly new IMF lending facilities.
The BWC is host to members from the world’s most prestigious universities, think tanks, banks, central banks and other geopolitical institutions.353 For the AIIB or the NDB to have a voice in the circle of captains of industry is a chance that can only be had through the corridors of the IMF.
One of the major concerns in the future reform landscape is an increasingly fragmented GFSN. Resulting in the slew of disjointed financial reform policies currently witnessed from every corner of the globe. The IMF is one of the few institutions that appear to hold the agenda of no individual nation above that of another.
They are also the only institution capable of global reform that correctly prescribes the need for unifying the GFSN. Moreover, in leveraging their neutral position, they stand
352 David Lipton, “Remarks by the International Monetary Fund’s First Deputy Managing Director David Lipton,” at the Bretton Woods Committee Annual Meeting (Washington, DC: IMF, 2016).
353 “Committee Members,” The Bretton Woods Committee, Last modified: January 2016. http://www.brettonwoods.org/page/committee_members.
JOOSUB 206 the best chance of implementing a global financial reform plan. Their public commitment to including emerging markets and developing economies (EMDC) in their broad market oversight gives other international actors something to hold against them in the event that they fall short of their word.
As financial markets see ever more integration and interdependence, the need for a large and coherent GFSN is without question. The IMF recognises this need, since moral hazard in one division of the system is no longer an isolated event, but something with unpredictable ripple effects.354 This research acted largely as a diagnostic work, with the nine key issues from chapter six highlighted as being the most pressing for the
IFC mandate.
In truth, the BWC, whose arms include the WB, IMF and WTO, is the best- equipped organization to facilitate sweeping financial reform. The main reason for this is because it is host to the most strategically connected power brokers from global governments and corporations. Together, their reach is more than sufficient to implement the post Bretton Woods, International Financial Code. Together, they have sufficient knowledge of history to not repeat the same mistakes.
354 Strengthening the International Monetary System, (2016), 31, op. cit. JOOSUB 207
CONCLUSION
CHAPTER 11 – RESEARCH FINDINGS
“We must not be afraid to say the truth, the world is at war because it has lost its peace. When I speak of war I speak of wars over interests, money, resources, not religion. All religions want peace, it’s the others who want war.”355
- Pope Francis, 2016 AD
(11.1) Existing Contributions
The hypothesis question sought to understand if major structural reform policies, in the form of the International Financial Code, could reduce systematic risk across the
IMS. In concluding, it will be ascertained as to whether or not the research was able to shed light on a hot subject that is the cause of much popular debate.
This research project started by evaluating the pedigree of current minor and major financial reform proposals. The literature review gives a snapshot of post-modern finance developments up to and after the Bretton Woods system. Following the Great
Recession of 2008, the worst economic crisis since the Great Depression of 1930,
Dodd-Frank was extemporaneously put together and this research determined that it gained only modest traction. Sharia-compliant finance was formally established a few decades ago as a promising nascent industry from which to draw parallels. It was further confirmed that as a practice, ‘Islamic’ finance is a misnomer that in fact has less to do with religion and more to do with socially just banking and economics.
355 “Pope Francis Warns World ‘is at War’ After Europe Attacks.” BBC News, 27 July 2016, accessed 28 July 2016, http://www.bbc.com/news/world-europe-36902882. JOOSUB 208
From the existing contributions to major reform proposals three sit at the forefront of the present reform landscape: the Chicago Plan, the SDR and a return to the gold standard. The IFC was conceived by referencing a selection of prerogatives from all three ideas, additionally, principles of Abrahamic law were used as a stencil.
The research analysis on the nine key areas of systematic importance revealed a buffet of issues. Some of these issues were more seasoned, such as fractional reserve banking and some of the issues are newer, such as the rising influence of CRA’s and the increasingly destructive nature of derivatives.
During the examination of the best path for reform, based on past strategies, certain patterns have emerged. All economies are clearly cyclical. Thus, reform proposals tend only to work in the short-term. Structural reform is rarely undertaken.
Debt is rising at a pace never before seen in history, also, innovation has more or less hit a rut. Hence, the way money/credit flows no longer allows for the maximum advancement of humanity. The risks of fraud and moral hazard have never been so severe and easily created digital commercial bank money has enriched few at the expense of many. Highly correlated financial markets mean that disruption in one segment is nearly impossible to contain. Consequently, these patterns reveal that financial reform has to be top down and unifying in that it reaches all corners of the
IMS. Reform has to be more than just financial; it has to be structural, where old economic paradigms are overhauled.
(11.2) Original Contributions
The IFC proposes long awaited structural transformation. Whilst there are many contributions to the literature of financial reform discussing full reserve banking and a JOOSUB 209 reversion to the gold standard, the culmination of this research project does have a unique edge.
The IFC is the first collection of articles to synthesize principles of Islamic finance with a modernized bimetallic standard. That is to say, it outlines equity based, profit and loss sharing facilitated by a fully backed SDR currency. By doing away with fractional reserve banking, fiat currencies, debt financing and derivatives, banking becomes simpler, more transparent and easier to understand. That being said, the IFC is not the first in recent history to propose smaller financial institutions and a change in the fee structures of CRA’s. Yet it contributes to the literature by providing a platform, or code, for the changes that many esteemed individuals have lobbied for in the past.
In November of 2015, Christine Lagarde gave a speech in Kuwait City at the
Islamic Finance Conference on the increasing promise in Islamic finance for inclusive economic growth. On speaking further about the merits of stability that such a system holds, she mentions the following:356
Islamic finance has, in principle, the potential to promote financial stability
because its risk-sharing feature reduces leverage and its financing is asset-
backed and thus fully collateralized. In addition, besides deposits, Islamic banks
offer profit-sharing and loss-bearing accounts that can help mitigate losses and
contagion in the event of banking sector distress. This leads, de facto, to higher
total loss-absorbing capital, one of the key objectives of the new global
regulatory reform… I think it is also fair to say that Islamic finance’s
356 Christine Lagarde, “Unlocking the Promise of Islamic Finance, Speech by Christine Lagarde, Managing Director, International Monetary Fund at the Islamic Finance Conference, Kuwait City, Kuwait.” 11 November 2015, accessed 1 March 2017, https://www.imf.org/en/News/Articles/2015/09/28/04/53/sp111115. JOOSUB 210
underpinning principles of promoting participation; equity, property rights and
ethics are all “universal values.”
To further validate the increasing need for emphasis on the value of the neutral principles of Sharia compliant finance, Lagarde concluded her speech by referencing the partnership between the IMF and the Islamic Development Bank (IDB) headquartered in Jeddah, Saudi Arabia. For the purposes of this research, their joint commitment to expand capacity development in Islamic finance is important substantiation of the tenets inside the IFC. Even more so because it is the IMF that is piloting the commitment, the very same institution that this research hypothesized would pilot the IFC.
It might appear difficult to test the metal of the IFC in real world circumstances; however, the success of this model of financing can be gauged on a smaller scale by observing existing institutions that operate within similar frameworks. The proof is in the pudding. The Bank of London and The Middle East Plc (BLME), is an independent
UK based wholesaler of Sharia compliant products and the largest Islamic bank in
Europe. Nigel Denison, Executive Director of the BLME, explains to Bloomberg in an interview why clients are increasingly moving towards a more vanilla form of financing:357
People feel comforted by some of the things we are not able to do by being
Islamic and what I’m thinking about here at the current time is that no one has to
worry about how many Greek bonds we have on our balance sheet or Spanish or
Portuguese bonds because they know the answer must be none. They’re all
357 Nigel Denison, interviewed by Bloomberg Television’s Faith in Finance, November 2012, http://www.bloomberg.com/news/videos/b/2b7d3bd5-d65e-4249-a565-3f9668e61de9. JOOSUB 211
interest-bearing instruments and we cannot hold any interest-bearing
instruments. So from a shareholder’s perspective there is a source of comfort in
knowing that we will be doing pretty much what we say we do on the tin.
The prologue of this research makes special references to the destructive nature of interest coupled with man’s sometimes-avaricious tendencies. Let alone Denison’s business practices, history’s greatest minds and lawmakers throughout every time period, culture and creed expressed the same sentiments. Having departed from their wisdom on multiple occasions, the negative effects are coming home to roost in perhaps more diabolical ways than ever before. The increasing polarity in wealth creates social disequilibrium, which more often than not has shown to end in social upheaval.
Specialists in economic history from the University of Tübingen, Professor Jörg Baten and Christina Mumme, have discerned that the greater the disparity in wealth, the greater the risk of civil war:358
If unequal division passes a certain level, the effects within a region are
enormous. The gap between rich and poor has widened significantly in recent
years. National and ethnic identities are often dug up to distract attention from
discontent over income difference.
Their outlook echoes the recent remarks cited by Pope Francis, who also tries to expose the real reality behind global instability. The past 30 years have witnessed a
358 Eberhard Karls, “Rich-Poor Gap and the Risk of Civil War.” Phys Org, 4 June 2014, accessed 15 August 2016, http://phys.org/news/2014-06-rich-poor-gap-civil-war.html.
JOOSUB 212 worrying increase in the Gini coefficients of the world’s major economies.359 Such examples include, The United States, South Africa, Britain, China and Germany.
Therefore, fertile ground for conflict is being sown on a scale larger than anticipated by
Baten and Mumme. As a world of seven billion individuals, a population larger than ever before, which amounts to seven billion bellies to feed, seven billion bodies to clothe, seven billion people who need shelter and whose happiness and welfare is at stake. Our current IMS has been shown to facilitate great wealth but also great disparity and the disequilibrium is unsustainable.
The increasing popularity in ethical finance is merely a reversion to banking in its golden form. It is a form of banking without interest, therefore without debt. It is a form of banking without derivatives, therefore without speculation. Finally, it is a form of finance that allows money to hold the integrity of its value and disallows special interest groups from abusing that value for their selfish ends. The IFC returns to banking in the time before the goldsmith, who in the fable of old, sought profit in excess of his custodian fees. Thus lending out his entrusted gold, anticipating an interest fee to be consumed entirely by himself and hoping that the gold was repaid before redemption.
(11.3) Research Limitations
Steve Jobs is credited for saying that “You cannot connect the dots looking forward, you can only connect them looking backwards.”360 The IFC is only as original as the past ideas it has borrowed from. Indeed, the research owes a great deal to previous minds that were ahead of their time. It has also entertained the reality of an
SDR reserve asset, paving the way for further research on its mechanics. Yet in the
359 “For Richer, For poorer.” The Economist, 13 October 2012, accessed 15 August 2016, http://www.economist.com/node/21564414.
360 Austin Kleon, Steal Like an Artist, (New York, NY: Workman Publishing Company, Inc, 2012), 68. JOOSUB 213 same way that past research has come up against limitations pointed out by the filtering eye of criticism, the IFC too has its drawbacks. In particular, four limitations to this research have been underlined.
1. Controversial. This research discusses the possibility for reform using
ideologies that are the current topic of heated global debates as well as
referencing ideas that some in financial circles view as antiquated. Gold has for
some time been an enemy to central bankers because it is viewed as restrictive,
despite the contradicting fact that they are its largest accumulators.361 Rising
Islamophobia has definitely contributed to many misconceptions and negative
views about Sharia law.362 Moreover, religious scripture in general would be
hard pressed to pass as stimulus for secular economic reform in an arena like the
Bretton Woods Committee annual meeting.
If that was not enough, the eradication of the derivatives market, although
proven to be highly destructive during the subprime crisis,363 has proponents
who will defend it tooth and nail.364 Whilst some advantages, such as the
mitigation of certain risk, cannot be denied, the systematic dangers far outweigh
anything else. It is for that reason the IFC takes a strong position on banning
these types of contracts.
361 Andrew Hecht, “Gold: The Metal That Central Banks Love to Hate.” Seeking Alpha, 8 February 2016, accessed 16 August 2016, http://seekingalpha.com/article/3873056-gold-metal-central- banks-love-hate.
362 Sam Levin, “Hate Crimes and Attacks Against Muslims Doubled in California Last Year – Report.” The Guardian, 29 July 2016, accessed 16 August 2016, https://www.theguardian.com/us- news/2016/jul/28/california-muslim-attack-hate-crime-report.
363 Michael Sivy, “Why Derivatives May Be the Biggest Risk for the Global Economy.” Time, 27 March 2013, accessed 16 August 2016, http://business.time.com/2013/03/27/why-derivatives-may-be- the-biggest-risk-for-the-global-economy/.
364 Ross DeVol, “Derivatives: Good for Risk Mitigation and Growth.” The Huffington Post, 26 April 2016, accessed 16 August 2016, http://www.huffingtonpost.com/ross-devol/derivatives-good-for- risk_b_9778838.html. JOOSUB 214
2. Feasibility. The purpose of this research was to evaluate inadequacies in the
current IMS and then try to as great a degree as possible to prove certain
changes as feasible. The problem is that it is not possible to predict with a degree
of certainty the results or reaction of the IMS to the large-scale reform
recommended in the IFC. The IMS is comprised of a myriad of players:
individuals, institutions and governments all of who behave in unpredictable
ways given the same changes. Historical examples of the benefits of fully
backed commodity money were provided, however, the SDR is still only in
limited use and despite the intentions of the IMF there is no way of confirming
its further proliferation and supremacy.
The only testable concepts lie in Islamic finance, the success of which can be
tracked and quantified in the industry’s growth. In only a few decades the
market for Sharia compliant products has grown from zero to approximately
USD2.1 trillion, with expectations that it could reach USD3.8 trillion by the end
of 2018. Yet it represents only one percent of the USD127 trillion global
financial market.365
By far the greatest risk in feasibility is outright rejection of the IFC by financial
institutions. Individuals may adjust, governments may be the facilitators of
reform, but the intermediaries, or banks, may abuse their position of prominence
to enforce and justify a profit oriented IMS that harbours moral hazard and
systematic risk.
365 Naveed Mohammed, “The Size of the Islamic Finance Market.” Islamic Finance, 14 June 2016, accessed 17 August 2016, https://www.islamicfinance.com/category/market-information/market- size-and-growth/. JOOSUB 215
3. Reliance on the IMF. Another limitation of the IFC is its significant reliance on
the SDR and adoption by the IMF. Former distinguished members of the IMF
were expressing strongly the institutions need to break free from the shackles of
the expired Bretton Woods administration. Perhaps even a name change to the
‘Bretton Woods Committee’ annual meeting would be a great way to shake off
the dust. Nevertheless, the current lack of transparency and neo-colonialist
selection methods for directors means that a potentially great institution will be
mired by controversial practices unless they act on the changes they speak of.
With regards to the SDR as a replacement to the US dollar as a global reserve
asset of choice, the obvious question must be asked, what if that never happens?
There is a chance, however small it may be, that the US dollar continues to rein
king. It may come to pass that the U.S. manages to deflate its debt obligation to
manageable levels and that the Federal Reserve of its own accord, implements a
commodity backing to the US dollar. On the other hand, the US dollar, as a fiat
currency printed without reservation, may continue to be the preferred medium
of exchange for pricing commodities and global trade. The prospect of a tenuous
US dollar reserve system, held on prolonged life-support cannot be ignored
because that is not too far from the current IMS structure.
Finally, the IMF may of course have no interest in the IFC and find its various
propositions such as interest free banking and a bimetallic SDR preposterous. Be
that as it may, to become an institution whereby other nations willingly sacrifice
their monetary and fiscal sovereignty, the IMF has a to endure a degree of
transformation.
JOOSUB 216
4. Fine print. The final drawback, although there may be others not at this time
apparent, is the need for greater detail in many of the IFC’s articles. Of
particular concern to critics will be Article II and Article IV, which lay out the
Resolution on Money and the Resolution of Derivatives respectively. It is clear
by their brevity and demand for grand modifications that many logistical issues
will need to be tackled. For example, if silver were to compliment gold as a
reserve asset, what is the correct ratio? Another example where more detail is
needed is on the specialised government sanctioned credit for large
infrastructure projects. Since the separation of deposit taking and credit issuing
will drastically reduce the credit available, the sometimes necessary (natural
disasters and humanitarian aid) and spontaneous expansion of the money supply
will need to be available in a thoughtful and fair manner. How will the
architecture of this credit provision work so that not only the most powerful and
influential institutions have access to it? This research provides a thorough
foundation for reform and the IFC is a solid skeleton, however, the way in which
the IFC is adapted for use will mean that many details still need configuration,
details that for practical considerations have been left or another research
project. It is with this in mind that the IFC paves the way for future research
dedicated to strengthening the IMS.
(11.4) Implications for Future Research
Research into the evolving dynamic of the IMS should be an ongoing endeavour that yields unrelenting facts and detailed maps for improvement. This project in particular, has uncovered three broad areas for further research. These are topics on JOOSUB 217 which there is scarce technical literature indicating how exactly certain reforms could assimilate into the IMS.
1. The rise of Ethical Finance. Having only recently congealed as an industry
with considerable potential, Sharia compliant finance gained particular attention
in the period following the Recession of 2008.366 It warrants further research
because it proposes ethical finance it a way that is still profitable. Indeed, this is
an important note because many incorrectly correlate socially just business with
reduced profit. When in fact, there is nothing about ethical finance that prohibits
profit generation.
PLS tools and asset-backed bonds can greatly assist in reducing systematic risk
in the IMS by transforming the balance sheets of banks. Further research in
universities and reform bodies can help change public perception towards them
and bring about greater understanding of Sharia law. As it stands most notions
of this law are largely inaccurate and stem from fear.367 Furthermore, the
remaining knowledge on how it pertains to finance goes no further than its
prohibition of interest.
This paper, specifically chapter seven, works to clarify the separation between
religion and ethical finance and also debunks any myths about reduced
profitability in socially just economics. However, more needs to be done at an
institutional level to promote the proliferation of truthful information on the
366 Mark Tutton, “Recession Sparks Interest in Islamic Finance.” CNN, 27 August 2009, accessed 25 August 2016, http://edition.cnn.com/2009/BUSINESS/08/25/islamic.finance/.
367 Paul F. McNamara. “10 Misconceptions About Islam.” Huffington Post, 23 September 2015, accessed 25 August 2016, http://www.huffingtonpost.com/paul-f-mcnamara/nine-common- misconception_b_8148946.html. JOOSUB 218
ethics of current Islamic banking to help erase any stigma in the minds of all too
many.
2. Gold, silver and the SDR. To have a bimetallic SDR will require careful re-
pricing of two extremely important commodities. Chapter eight looked at the
potentially drastic changes in the price of gold with 100 percent backing of
current US dollars in circulation. US dollars were referenced because of their
role as international reserve asset.
That being said, if the US dollar is to be replaced by SDR’s as a chosen global
reserve asset, then a major question must be asked: ‘what is the correct amount
for the first SDR issuance?’ This answer, which determines the desired price of
gold and silver, will have a momentous impact on the acceptance of the IFC as
well as a bimetallic standard in general.
The next major calculation that needs to be addressed is the ratio between gold
and silver. This alone is a major endeavour because it is the foundation upon
which the architecture of the IFC rests. This research did not proposal a formal
ratio but investigated possible options, outlines in chapter eight, which are
declared areas for future research.
Notable authors, James Rickards and Tariq Alrifai were cited in this project
because of their individual attempts to deduce the appropriate price of gold for
representative money. Essentially, they divided outstanding high-powered US
dollars (M0) by stockpiled gold. The resulting value of gold, at today’s prices,
was USD42,858. This straightforward approach may later prove to be the best
and most realistic, however at this point, the stated position of this research with
regards to gold pricing and the ratios between gold and silver is open and JOOSUB 219
flexible. Moreover, neither Rickards nor Alrifai recognize the benefits of
complimenting gold with silver in the pricing mechanism. Although, this
research is certainly not alone in the bimetallic suggestion. The authors have
given a respectable indication of where the IMS can expect to see the price of
gold with 100 percent backing of a reserve asset like the SDR. However, much
further study is needed to calculate the pricing and ratios of gold and silver vis-
à-vis he SDR.
3. Derivatives. These contentious instruments are far from short on literature
painting them as consorts with the devil. However, few who have recommended
their abolition have detailed the methodology by which they can be wound down
and terminated. Since the majority of the contracts outstanding are OTC and not
involving centralized exchanges, they are complicated to track with
disproportionate notional values.
The Basel Accords (III) only removed the 50 percent ceiling on risk weights that
can be assigned to OTC derivatives, but financial institutions may still assign
weights lower than 50 percent without any obstacles. The BIS represents all that
has been done to tackle the regulation of these contracts, clearly indicating the
room for considerably more work.
Since the IFC is taking what some might call a staunch stance towards any
systematic issues, the implications for future research demand additional
technical study that outlines how certain ends might be achieved.
JOOSUB 220
(11.5) Closing Remarks
Keynes acknowledged, in a rather Aristotelian vein, that the excess of two virtues, enterprise and thrift, transform quickly into greed and avarice. Thus, the ‘good life’ is endangered when the acquisition of money for its own end, comes to be seen as intrinsically valuable.368 The preservation and advancement of the ‘good life’, whether in its philosophical or practical form; that is the point of this research and all others like it.
Can structural reform reduce systematic risk in the IMS? The intuitive answer, looking back at the nine areas analysed, is ‘yes’. However, the research findings have shown how previous and existing reform models have failed to provide a socially just and sustainable economy. Yet, the research was not able to provide any quantifiable or numerical proofs for a bimetallic SDR as outlined in an ethical code. On the other hand, there is no known literature that can reference modern attempts at structural economic reform and prove its inadequacy either. That being said, several references to historic monetary systems as well as current institutions do provide the substance needed to verify the Articles of the IFC and the new paradigms therein.
Therefore, it can be said that the hypothesis question remains unanswered on the grounds that there was a lack of testable data. Instead, the research has presented sufficient criteria to deduce that the propositions in the IFC can do nothing but lead to a reduction in systematic risk in the IMS. For academic purposes, however, it is not sufficient enough to declare the IFC as ‘tried and tested’, ergo; the research proves it as a solution to systematic risk.
Going forward, an assessment of the current geopolitical landscape demands macroprudential reform that assists in greater inclusion of all international actors.
368 Robert Skidelsky, Keynes: Return of the Master (Great Britain: Penguin Group, 2009), 138. JOOSUB 221
Marginalization and blame can only further fuel conflicts and division. This research belongs to a greater school of thought that calls for reform, which limits system wide distress, which acknowledge the highly correlated nature of financial markets, and recognizes that the post Bretton Woods; fiat monetary regime is calamitous and biased.
It time for those anointed in positions of leadership, such as the BWC, to rise from the ashes of history and come to the forefront of brave decision making.
In this way, we return to the graceful words of Keynes, who in Auri Sacra
Fames, posits the apotheosis of gold when there are no other options;369
Gold is out of sight – gone back again into the soil. But when gods are no longer
seen in a yellow panoply walking the earth, we begin to rationalize them; and it
is not long before there is nothing left… Thus gold, originally stationed in
heaven with his consort silver, as Sun and Moon, having first doffed his sacred
attributes and come to earth as an autocrat, may next descend to the sober status
of a constitutional king…
369 John Maynard Keynes, A Treatise on Money (Great Britain: The Royal Economic Society, 1930), 161-163. JOOSUB 222
EPILOGUE
“I think the internet is going to be one of the major forces for reducing the role of government. The one thing that’s missing but that will soon be developed, is a reliable e-cash.”370
- Professor Milton Friedman (1912-2006)
(12.1) An Ode to Blockchain
The period in which the literature review for this study was conducted saw an explosion in popularity of the rapidly evolving world of digital currencies, also known as cryptographic currencies, or cryptocurrencies. As such, cryptocurrencies and the underlying blockchain technology have shown that despite mixed opinions amongst governments, institutions and individuals, there is promise for serious economic application.
Since the popularity surrounding this topic is so recent, sources available are not always reputable and available information is often conflicting. Therefore, it is necessary for the epilogue of this project to attempt, in layman terms, an explanation of the workings of blockchain technology and its potential function in the IMS through
Bitcoin (BTC) or other such digital means of payment. As a result, the depth reached to describe the blockchain can be considered as only functional, but not to the point that the concepts are totally diluted. The revolutionary concepts behind blockchain and digital currencies would render this project immediately out of date were they not addressed in some degree.
370 Daniel Cawrey, “How Economist Milton Friedman Predicted Bitcoin.” CoinDesk, 5 march 2014, accessed February 10 2018, https://www.coindesk.com/economist-milton-friedman-predicted- bitcoin/. JOOSUB 223
Unfortunately, incorporating these new phenomena in the body of the theory was unfeasible, since the point at which these phenomena gained relevance was simultaneously the point at which this study was closing. That being said, the epilogue will conclude with an added proposition on digital currencies and their potential role in the realm of ethical financial reform. Additionally, these final recommendations will reference the solutions to reducing systematic volatility formed in the body of the text.
Therefore, this epilogue can be read as an extension to the existing paper, ‘Reducing
Systematic Risk with an International Financial Code’, or as a separate analysis on the blockchain revolution.
(12.2) Decentralization Revolution
Blockchain technology was originally developed as part of the digital currency
Bitcoin. But the two are not the same. Blockchain can support a wide range of
applications, and it’s already being used for peer-to-peer payment services,
supply chain tracking and more.371
Only one generation ago, when mothers and fathers wanted to teach their children about the seven wonders of the world, they would have typically consulted a large copy of a Britannica.372 Keeping in mind that the brainchild of Jeff Bezos was still brewing in his garage, this costly text would have to be procured from a local bookstore.
371 “Blockchain – The New Technology of Trust.” Goldman Sachs, accessed 12 February 2018, http://www.goldmansachs.com/our-thinking/pages/blockchain/index.html?cid=sch-pd-google- blockchain-searchad-201706--&mkwid=SkF2mF1C.
372 Lorne Lantz, “New Kids on The Blockchain.” TED Talks, 23 December 2016, accessed 12 February, 2018, https://www.youtube.com/watch?v=KP_hGPQVLpA.
JOOSUB 224
Or perhaps being not readily available, one would place a special order through a dedicated sales agent and wait until delivery.
Encyclopaedia Britannica, the 244-year-old publisher behind this magnum opus, cultivated its content from 4,000 original and well respected contributors.373 The model for content distribution was centralized. When we learnt about the seven wonders of the world, we placed our trust in the institution providing knowledge on the subject, in this instance, the Encyclopaedia Britannica. Verification of, say, the height of the pyramids would require consulting another text, or even an actual trip to Cairo just to corroborate the other two or three sources at arm’s length. In other words, verification was cumbersome and expensive, we had no choice but to trust in the mighty Encyclopaedia
Britannica. Such is just one of many issues behind centralized models, reflected in the below diagram.
Figure 12.a
373 Julie Bosman, “After 244 Years, Encyclopaedia Britannica Stops the Presses.” The New York Times, 13 March 2012, accessed 13 February 2018, https://mediadecoder.blogs.nytimes.com/2012/03/13/after-244-years-encyclopaedia-britannica- stops-the-presses/.
JOOSUB 225
Today, a discussion involving the seven wonders of the world is quite incomplete without referencing Wikipedia. The wiki engine is powered by more than
200,000 active monthly content contributors, not all of whom have entirely genuine credentials, but who are nonetheless avid in ensuring the up to the minute provision of information.374 Most importantly, if a charlatan archaeologist were to update the
‘pyramids’ page on Wikipedia to indicate that there are only two great pyramids and not three, other contributors would be able to quickly invalidate the tampered contribution.
The advent and subsequent worldwide saturation of the internet enabled this decentralization of content. Whereby the contributors of content can be almost any relevant person or entity, all of whom are able to act as verification and security agents.
Accordingly, the third party, Encyclopaedia Britannica, was made redundant. Thus the diagram below, illustrates the world of decentralized content.
Figure 12.b
374 “Wiki.” Wikipedia, accessed 4 March 2018, https://en.wikipedia.org/wiki/Wiki.
JOOSUB 226
Blockchain technology is the means by which other areas in the economy can be decentralized. In the world of tomorrow, third party intermediaries who used to be formally relied upon for their centralized role in the provision of goods and services will have to evolve or be made redundant. This threat has virtually no industry bias.
Commerce as we know it is on the brink of transformation. For the purposes of this study, the ramifications of changes in ground zero are most important, that being, the revolution of ‘money.’
(12.3) The End of Cash
A purely peer-to-peer version of electronic cash would allow online payments to
be sent directly from one party to another without going through a financial
institution. Digital signatures provide part of the solution, but the main benefits
are lost if a trusted third party is still required to prevent double-spending.375
To summarize, the essence of cryptocurrencies, the most popular of which is
Bitcoin, which runs on its own blockchain technology platform, is that it is a decentralized, direct peer-to-peer means of exchange. Bitcoin being the store of value in question. By using digital currency, payments can be made to anyone, anywhere, without the need for third party intermediation. Or, in other words, the direct consensus of multiple users replaces central banks or independent payment processors as the only central authorities in verifying transactions. Moreover, transactions can happen
375 Satoshi Nakamoto, “Bitcoin: A Peer-to-Peer Electronic Cash System,” (2008): 1, accessed 15 February 2018, https://bitcoin.org/bitcoin.pdf.
JOOSUB 227 instantaneously with fractional fees. Every transaction is stored on the blockchain, a shared and immutable ledger, adding greatly to verifiability and trust.
There are many other digital currencies that use the Bitcoin blockchain protocol or the ‘Ethereum’ blockchain protocol. Ethereum is another such currency with different attributes but the same basic purpose as Bitcoin. However, after refuelling a car, one cannot yet just pay for the gas using his/her Bitcoin. It is not that simple. Hence, what problems does the blockchain actually solve? To understand more the importance and value of digital money to our current IMS, one needs to understand the value proposition. Given the breadth in the evolution of cryptographic currencies at large, the focal value proposition is in the underlying blockchain technology.
(12.4) Blockchain Decoded
The blockchain is an endless ledger of transactions open to absolutely anyone.
This is known as distributed ledger technology (DLT). When a new node joins, they get a copy of the existing ledger. Therefore, it is considered to be a ‘distributed ledger’. As a series of transactions is executed, the data is organized into individual chunks known as ‘blocks’. These blocks are then placed one on top of the other using cryptography, finally creating what everybody knows as the ‘blockchain.’ To summarize, the blockchain performs two essential functions: 376
1. It gathers data into blocks.
2. It then strings the blocks together securely using cryptography.
376 Goldman Sachs, (2018), op. cit.
JOOSUB 228
Each block in the chain is made up of three components;
1. The data.
2. The hash of the block.
3. The hash of the preceding block.
A hash function is a mathematical process that takes data of an arbitrary size and converts it into data of a fixed size.377
In the instances of the Bitcoin blockchain, each block contains data on the sender, receiver and the value of the transaction. Each block also contains its own unique hash ‘timestamp’ in the form of an alpha-numeric code. If an entity tries to change the data stored in a block, this will in turn change the hash code, making these timestamps useful in detecting changes in a block. The final element in each block is the hash of the preceding block. Thus, completing the formation of the blockchain. The diagram below is a physical visualization of how the blockchain connects using cryptography in the form of hash timestamps.
377 Corin Faife, “Bitcoin Hash Function Explained.” CoinDesk, 19 February 2017, accessed 15 February 2018, https://www.coindesk.com/Bitcoin-hash-functions-explained/. JOOSUB 229
Figure 12.c
Since the first block has no proceeding blocks it is known as the ‘genesis block’.378 The unique hash signature behaves like a digital timestamp. Therefore, if anyone tries to tamper with the information inside a block, it will automatically alter the timestamp, invalidating all previous blocks on the distributed ledger. Accordingly, it can be said that each blocks validity is dependent on the preceding blocks validity.
Furthermore, the information is added sequentially, preventing double entries.
Nonetheless, the ‘fingerprint’ quality of a hash is not enough to protect against a hack piloted by a supercomputer. A device with enough computing power could theoretically change a hash and then recalculate all subsequent hashes. To protect against such an anomaly, blockchains have something called ‘proof-of-work’ (POW).
(12.5) The Useful Puzzle
The POW mechanism is an algorithm that acts like a puzzle which needs to be solved each time before a new block can be validated and added onto the distributed
378 Nakamoto, (2008), 4, op. cit. JOOSUB 230 ledger. The POW calculation intentionally slows down the creation of every new block by approximately 10 minutes. Consequently, to tamper with the POW of one block would require that all POW’s for all other blocks would also need to be recalculated.
The POW and hashing aspects of the blockchain ensure its security, but also mean that adding new blocks to the Bitcoin blockchain in particular, require substantial amounts of computing power. The mining process, which involves individual users and their computers, otherwise known as nodes, is the process which validates transactions, solves the POW and in turn creates Bitcoin. Mining therefore, is the means by which new blocks of data are validated and added to the ledger. This mining is the process which consumes exorbitant amounts of electricity, it will be addressed in more detail later on.
(12.6) Absolute Transparency
The crux in the blockchain phenomena, which affords it true decentralization, is that instead of using a central institution to manage the blockchain, it uses a peer-to-peer
(P2P) network. This is to say, that absolutely anyone is free to join or leave the blockchain at any point. When a node joins the network, they receive a full copy of the ledger of transactions. Therefore, when a new block is created and distributed to the network, it is viewable by everyone. Each node then verifies the block via the hashing and POW mechanisms to ensure that everyone is looking at the same block of data free of any anomalies. When the majority of nodes on the network confirm that the block in question is valid, they create consensus. The network of nodes mutually agrees or disagrees on the validity of every new block. Any blocks that have been tampered with will be rejected by the network because of a lack of consensus amongst all nodes. JOOSUB 231
That being said, to effectively ‘hack’ the blockchain or tamper with one of the blocks, a hacker would need to re-solve the cryptographic hash and POW for all preceding blocks. Most importantly, the hackers computing power would need to account for more than 50 percent of all the nodes currently on the network. Only after overwhelming more than half of the networks consensus would the tampered block then be accepted, a virtually impossible scenario.
To better illustrate the value of the networks transparency an example of everyday banking can be used.
If one were to check their account balance via an online banking portal, the basic ledger would display a series of credits and debits. Money going in, money going out.
In this centralized scenario, one would have to trust the bank in question when they display a current account balance. The bank and its ledger of transactions are the only central authority and they are the last stand in verification, authentication and validation.
On the other hand, in a decentralized payments network, thousands of other computers are simultaneously updating their respective ledgers with current transactions. Whose ledger is a user to trust? Trust the blockchain. One of the fundamental problems that the blockchain solves is the ‘managed trust’ problem.
The ramifications of a distributed digital ledger are far reaching, not just applicable to payment systems. It can apply to the supply chain of pharmaceuticals, the history of properties on land registries, corporate audits, art auctions, contractual agreements and government elections. The applications are endless. A consensually validated, immutable ledger, viewable by all, removes the obligation to trust a third party, centralized intermediary. This is a quantum forward over the traditional ledger.
JOOSUB 232
(12.7) Mining
The processes described above are completely unfamiliar to the vast majority of individuals. Yet despite its complexity, describing how the blockchain works is vital because its effects will eventually be felt by everyone. The question must be asked of how this innovation all comes together.
The blockchain can be thought of as a process which decides how the distributed ledger is updated. In the instance of the Bitcoin blockchain, every 10 minutes a new block of transactions is added to the ledger. During this time, all the nodes are sending data to the blockchain ledger, but because the ‘sends’ are uniquely timestamped, data will always be added in the correct order.
In order to ‘decide’ which node is allocated to update the blockchain, they all have to compete by dedicating their computing power to solving the energy intensive cryptographic hash. The POW algorithm then testifies to the energy consumed. The nodes with more computing power have a greater chance of ‘winning.’ Every 10 minutes, a node will have succeeded in solving for the POW and thus nominates to add a block of transactions to the ledger. Before this happens, at least half of all the other nodes have to confirm that the winning node did indeed solve the mathematical puzzle correctly and that the block of transactions is also valid. Thus, the blockchain has mechanisms, i.e. hash functions and POW, whilst concurrently enabling it to work, also afford it its innovative security.
The phenomenon of ‘mining’ has spawned a whole new industry of its own.
Individuals and investors have established mining farms,379 housing advanced hardware
379 Harvey Gavin, “Inside South London’s Bitcoin Mining Farm When the Cryptocurrency is Born.” Sunday Express, 13 January 2018, accessed 15 February, 2018, https://www.express.co.uk/news/uk/904234/bitcoin-farm-london-what-does-the-inside-of-a- cryptocurremcy-mine-look-like.
JOOSUB 233 such as application specific integrated circuit (ASIC) chips dedicated to the sole purpose of verifying transactions. Some of these firms further host mining pools,380 where individuals from around the world can dedicate their computers central processing unit
(CPU) to the power-hungry verification of transactions. Firms creating the ASIC chips and hardware alike have seen stupendous increases in global demand for their machinery and components.381 The likes of Samsung have even joined the ASIC production line so as not to miss out on this lucrative trend. Naturally, mining is profitable. Nothing else would induce the rapid scaling of the previously non-existent cryptographic mining industry.
(12.8) The Birth of Bitcoins
With reference to the most well-known blockchain, the Bitcoin blockchain, in an effort to slowly and randomly distribute Bitcoins, a reward is allocated to whichever node is the winner at solving the block in question. Once a node has Bitcoins and they wish to send or transfer them, a cryptographic hash signature is generated. As explained earlier in order to generate the signature, the protocol requires a reference to the input of previous Bitcoins. This is the key difference between the blockchain ledger and a general accounting ledger, which otherwise only tracks transactions based on existing balances. Every Bitcoin on the blockchain can be traced back to its preceding transaction. Therefore, tampering with any signature would immediately invalidate it and halt the transaction. The ‘cryptographic’ aspects are thus brought to light. The
380 Arun, “Bitcoin Mining: Understanding Mining Pools and Increasing Daily Pay-outs.” Hackernoon, 29 December 2017, accessed 17 February 2017, https://hackernoon.com/bitcoin-mining- understanding-mining-pools-and-increasing-daily-payouts-2b3b01eb87ba.
381 James Vincent, “Samsung’s Now Making Chips Designed for Cryptocurrency Mining.” The Verge, 31 January 2018, accessed 18 February 2018, https://www.theverge.com/2018/1/31/16954366/bitcoin-cryptocurrency-mining-asic-chips- samsung. JOOSUB 234 digital signature is made using complex mathematics, elliptical curve digital signature algorithms (ECDSA) and mathematical trap doors, the details of which are beyond the scope of this analysis. The next question is, where do the Bitcoins come from to begin with?
The legendary creator(s) of Bitcoin has to date never revealed his/her true identity. Discovering the entity behind the creation of this new unit of account is a considerable topic of its own and well beyond the scope of this epilogue. Despite much speculation and conspiracy, the original white paper outlining the Bitcoin framework was published under the pseudonym Satoshi Nakamoto.382 On January 3rd 2009, three months after the collapse of Lehman Brothers,383 the first Bitcoin block was mined.
Known as the genesis block, it awarded 50 Bitcoins. This is why solving mathematical puzzles to add blocks is called ‘mining,’ even though the real purpose is to verify transactions and safeguard the blockchain.384
At the time of writing this study, approximately 16.8 million Bitcoins have been mined in total.385 Why some have dubbed Bitcoin as ‘digital gold’ is because it is in fact finite.386 The Bitcoin blockchain protocol dictates that there will only ever be 21 million
Bitcoins in existence. That is to say no more that 21 million can ever be mined, but even
382 Nakamoto, (2008), op. cit.
383 Investopedia Staff, “The Collapse of Lehman Brothers: A Case Study.” Investopedia, 11 December 2017, accessed 18 February 2018, https://www.investopedia.com/articles/economics/09/lehman- brothers-collapse.asp.
384 “How Bitcoin Works Under the Hood.” Curious Inventor, 14 July 2013, accessed 17 January 2018, https://www.youtube.com/watch?v=Lx9zgZCMqXE&t=197s.
385 “Bitcoin Block Reward Halving Countdown.” Bitcoin Blockhalf, 15 February 2018, accessed 15 February 2018, http://www.bitcoinblockhalf.com/.
386 Jeff Cox, “Novogratz: Bitcoin is ‘Digital Gold’ and Will End the Year at USD10,000.” CNBC, 21 November 2017, accessed 16 February 2018, https://www.cnbc.com/2017/11/21/novogratz- Bitcoin-is-digital-gold-and-will-end-the-year-at-10000.html.
JOOSUB 235 then, the blockchain can of course continue to add blocks of transactions to its ledger.
The table below shows the past, present and predicted future of Bitcoins in circulation.
Projected Bitcoin Production 2009 ~ 2140 Bitcoin Block Reward Halving Countdown Date Block BTC/ Year Start BTC BTC End BTC BTC % End % block (estimate) Added Increase BTC Limit 3/1/2009 0 50 2009 0 2,625,000 2,625,000 Infinite 12.5% 22/4/2010 52,500 50 2010 2,626,000 2,625,000 5,250,000 100% 25% 28/1/2011 105,000 50 2011 5,250,000 2,625,000 7,875,000 50% 37.5% 14/12/2011 157,500 50 2012 7,875,000 2,625,000 10,500,000 33.33% 50% 29/11/2012 210,000 25 2013 10,500,000 1,312,500 11,812,500 12.50% 56.25% 9/10/2013 262,500 25 2014 11,812,500 1,312,500 13,125,000 11.11% 62.5% 11/8/2014 315,000 25 2015 13,125,000 1,312,500 14,437,500 10% 68.75% 29/7/2015 367,500 25 2016 14,437,500 1,312,500 15,750,000 9.09% 75% 9/7/2016 420,000 12.5 2016 15,750,000 656,250 16,406,250 4.17% 78.125% 23/7/2017 472,500 12.5 2018 16,406,250 656,250 17,062,500 4% 81.25% 525,000 12.5 2019 17,062,500 656,250 17,718,750 3.85% 84.375% 577,500 12.5 2020 17,718,750 656,250 18,375,000 3.7% 87.5% 630,000 6.25 2021 18,375,000 328,125 18,703,125 1.79% 89.063% 682,500 6.25 2022 18,703,125 328,125 19,031,250 1.75% 90.625% 735,000 6.25 2023 19,031,250 328,125 19,359,375 1.72% 92.188% 787,500 6.25 2024 19,359,375 328,125 19,687,500 1.69% 93.75% Figure 12.d387
As the table shows, the Bitcoin protocol ensures that production of BTC per block is halved every four years. Therefore, the release rate drops dramatically, yet in a predictable fashion as time passes. Even with an ever-increasing number of nodes on the network, the BTC reward is simply split more so amongst the miners. The table shows that by the year 2024 approximately 93.75 percent of all Bitcoins in existence are predicted to have been mined.
Practically, Bitcoin production follows an asymptote tending towards 100 percent release of all 21 million Bitcoins. This figure is widely estimated to be reached in the year 2140.388 However, the limited number of Bitcoins in circulation will not restrict its circulation because it is possible to send amounts as small as 0.00000001
387 Blockhalf, (2018), op. cit.
388 “What Happens When All 21,000,000 Bitcoins Have Been Mined?” CryptoCoin Mastery, 21 October 2017, accessed 19 February 2018, https://cryptocoinmastery.com/what-happens-when- all-Bitcoins-have-been-mined/.
JOOSUB 236
Bitcoin (1/100,000,000), ironically known as one ‘Satoshi’ in the world of cryptographic currencies.389 A live copy of the Bitcoin ledger can be viewed online by anyone at any time at https://blockchain.info/blocks.390 The ledger displays all the information described and more. The block numbers are viewable, the number of transaction in the said block, the hash signature, the POW, the block reward and much more. As Figure x indicates the current reward per block solved in 12.5 BTC and at the time of writing we are currently at block 507,618.
Until such time that all Bitcoin rewards have been extinguished, they are the de facto incentive for nodes to continue mining and solving for block transactions. It is predicted that when there are no more Bitcoins in existence, miners are likely to include transaction fees for the processing of blocks. This is not currently the case, because miners have the block rewards as their primary incentive. However, it is likely that when transaction fees are implemented transactions will be processed onto the ledger based on their fees. Higher fees, referred to as ‘gas’ in some circles, would result in faster processing times whilst transactions with no fees could possibly not be processed at all. Albeit, transaction fees charged to solve for blocks would still be substantially lower than existing third party fees from i.e. banks or payment processors.391
389 What is a ‘Satoshi?’ Stack Exchange, 12 May 2014, accessed 19 February 2018, https://bitcoin.stackexchange.com/questions/114/what-is-a-satoshi.
390 “Previous Blocks Mined on: (Live Date).” Blockchain, live, accessed 20 February 2018, https://blockchain.info/blocks.
391 “A Practical Guide to Accidental Low Transaction Fees.” Hackernoon, 9 March 2017, accessed 21 February 2018, https://hackernoon.com/holy-cow-i-sent-a-bitcoin-transaction-with-too-low-fees- are-my-coins-lost-forever-7a865e2e45ba.
JOOSUB 237
(12.9) Bitcoin Mania
The recent increase in the demand for Bitcoins has afforded it a meteoric rise in price. The chart below illustrates the rise in price of Bitcoin from 2009, when it was worth nothing, 0.00USD, to its currently market value of around USD10,000 at the time of writing.
Bitcoin Price Movement (BTC/USD) Bitfinex Historical Data 2009 - 2018
$20,000.00 $18,000.00 $16,000.00 $14,000.00 $12,000.00 $10,000.00 $8,000.00 Price (USD) $6,000.00 $4,000.00 $2,000.00
$0.00
09 14 13 12 17 10 15 11 16 11 16 10 15 12 17 09 09 13 14 14 12 17 ------Jul Jul Jan Jan Jun Jun Oct Oct Apr Feb Sep Feb Dec Dec Aug Aug Nov Nov Mar Mar May May Date
Figure 12.e392
The availability of hard data during Bitcoins earlier days is scarce. Mostly because the price was so low and its existence so irrelevant, that nobody bothered to create official records. If an investor had bought USD100 worth of Bitcoin in early 2010 it would be worth the equivalent of USD10 million at the time of writing.
These almost irrational rises in price have caused many to liken the Bitcoin phenomenon to that of the Dutch Tulip Mania. During early 17th century Netherlands,
392 “Bitcoin US Dollar.” Investing.com, 15 January 2018, accessed 15 January 2018, https://uk.investing.com/currencies/btc-usd-historical-data.
JOOSUB 238 newly imported tulip bulbs from Turkey caused a socio-economic stir.393 After gin, herrings and cheese, tulip bulbs were the Netherlands fourth largest import. At its peak, a single bulb was reported to have been changing hands up to ten times a day.394 A combination of greed and fear of missing out (FOMO) resulted in speculative values of a single bulb equaling to that of a whole house or more. The entire saga peaked in 1636 and then crashed all too suddenly in February 1637. Some historians propose that the crash was due to the fact that routine tulip auctions were taking place in the municipality of Haarlem, an area which saw an outbreak of the bubonic plague.395
Choosing between death or riches, buyers refused to turn up. Such was the Dutch
Golden Age.
In reality, the myriad reasons for owning Bitcoin can be boiled down to just two.
First, is for speculative reasons. Greed and FOMO induce individuals into jumping onto the crypto bandwagon because massive fortunes have been made by early investors, now dubbed as Bitcoin millionaires, and it never looks too late to ‘get in.’ Second, is the eventual and hopeful end use. In that owning Bitcoin now, whilst the price is perceived as low, might later afford its user massive gains in material wealth when or if Bitcoin ever becomes a widely accepted means of payment.
There are of course many in the international community, who represent a fare cross-section of both private and public sectors and who truly feel that Bitcoin and its accompanying blockchain technology could not be further from a tulip bulb. This notion
393 Daniel Shane, “Bitcoin vs History’s Biggest Bubbles: They Never End Well.” CNN Money, 8 December 2017, accessed 20 February 2018, http://money.cnn.com/2017/12/08/investing/Bitcoin-tulip-mania-bubbles-burst/index.html.
394 Peter M. Garber, “Tulipmania,” Journal of Political Economy, Issue 3, (1989): 535-560, accessed 22 February 2018, https://www.journals.uchicago.edu/doi/10.1086/261615.
395 Garber, (1989), op. cit.
JOOSUB 239 is further evidenced by the growing market cap of Bitcoin and other related cryptocurrencies. Although highly volatile, Bitcoin has a market cap of USD147 billion, which accounts for 35 percent of all cryptocurrencies in circulation.396
From the perspective of the private sector digital currencies represent an interesting and chic development as a means of payment. Bitcoin has been elevated to the rank of an accepted exchange of value by many renowned companies. Expedia,
Microsoft, Virgin Galactic, Subway and the software creator Zynga are just a few examples of companies who have done their due diligence and have decided that they are comfortable with the safety and reliability of Bitcoin.397
On the other hand, banking institutions have not made their discomfort with
Bitcoin and the rise of decentralized currency a secret. Jamie Dimon, chairman and
CEO of JP Morgan Chase, has called Bitcoin an outright fraud.398 Other banks such as
Bank of America and Citigroup have also gone so far as to bar their customers from purchasing cryptographic currency with their bank-issued credit cards.399 It is becoming apparent that decentralized currencies threaten to overturn the IMS as we known it.
International public sectors have varied widely in their positions. In general, most governments recognize the value in blockchain technology and its broad industry
396 “Cryptocurrency Market Capitalizations.” CoinMarketCap, 15 February 3018, accessed 15 February 2018, https://coinmarketcap.com/.
397 Mariam Nishanian, “8 Surprising Places Where You Can Pay with Bitcoin.” Business Insider UK, 11 October 2017, accessed 23 February 2018, http://uk.businessinsider.com/bitcoin-price-8- surprising-places-where-you-can-use-2017-10.
398 Panos Mourdoukoutas, “Why Big Banks Attacked Bitcoin.” Forbes, 14 September 2017, accessed 24 February 2018, https://www.forbes.com/sites/panosmourdoukoutas/2017/09/14/why-big- banks-attacked-bitcoin/#414882426c53.
399 Evelyn Cheng, “JPMorgan Chase, Bank of America & Citi Bar People from Buying Bitcoin with A Credit Card.” CNBC, 2 February 2018, accessed 24 February 2018, https://www.cnbc.com/2018/02/02/jpmorgan-chase-bank-of-america-bar-Bitcoin-buys-with-a- credit-card.html.
JOOSUB 240 application, but few see the value in Bitcoin per se. For example, the Australian government under Malcolm Turnbull has made substantial investments towards integrating blockchain into the economy.400 The Swiss canton of Zug has declared its self the unofficial ‘crypto valley.’401 Amongst other encouraging prerogatives, like helping set up Bitcoin ATM’s across the country, it hosts annual blockchain conferences to stimulate the movement. The Swiss town of Chiasso has even gone so far as to accept Bitcoin from individuals towards the payment of taxes.
Nevertheless, authorities have a legitimate reason for their concerns. The governments of China, Korea, Japan and Singapore to name a few, have at least expressed caution to their citizens and at most, have cracked down on miners and restricted their electricity consumption.402 China being the biggest player on the Bitcoin mining scene, Bitcoin mining’s energy consumption is exorbitant. Current consumption of 29.05 terawatt hours (TWh) is equal to 0.13 percent of total global energy consumption. That further equates to using more electricity than 159 individual countries!403 Analysts from Morgan Stanley have predicted that mining power consumption could increase to 140TWh by 2018 alone, approximately 0.6 percent of the
400 Eryk Bagshaw, “Turnbull Government Invests in Blockchain.” The Sunday Morning Herald, 22 November 2017, accessed 22 February 2018, https://www.smh.com.au/business/the- economy/turnbull-government-invests-in-cryptocurrencybased-company-for-the-first-time- 20171121-gzplb4.html.
401 Hugo Miller, “Welcome to Crypto Valley.” Bloomberg Businessweek, 10 October 2017, accessed 24 February 2018, https://www.bloomberg.com/news/articles/2017-10-10/welcome-to-crypto- valley.
402 Sara Hsu, “China’s Shutdown of Bitcoin Miners is Not Just About Electricity.” Forbes, 15 January 2018, accessed 25 February 2018, https://www.forbes.com/sites/sarahsu/2018/01/15/chinas- shutdown-of-bitcoin-miners-isnt-just-about-electricity/#12bf9166369b.
403 “Bitcoin Mining Now Consuming More Electricity than 159 Countries Including Ireland & Most Countries in Africa.” Power Compare, November 2018, accessed 23 February 2018, https://powercompare.co.uk/Bitcoin/.
JOOSUB 241 global total. Given the pressing nature of climate change and the need for greener power generation, Bitcoin mining comes at a precarious time.
Fraud, money laundering, tax evasion, terrorist financing, drug trafficking and other illicit activities are believed to be significantly better enabled through the anonymous Bitcoin network. However, the most widely used currency in all underground activities is still the US dollar.404 The 100-dollar bill is a stable store of value that for decades has allowed criminals to transfer wealth undetected, in a P2P fashion and with relative ease. Aside from the mind-boggling electricity consumption,
Bitcoin and decentralized currencies are painted to have created just as many problems as solutions.
(13.0) Funny Money
A more accurate analogy of the current cryptocurrency landscape is akin to that of the dotcom bubble of the 1990’s. The surge in the rising equity markets was characterized by dubious new entrants to the technology market, lured by the promise of capitalizing on the internet sensation.405 When the bubble burst by the end of 2001 there were some winners, i.e. Dell, Amazon, Cisco and Oracle, but mostly losers. The birth of the internet saw a global network of computers that definitely transformed the world for the better, much like the potential in blockchain, but not all players truly delivered value to consumers.
404 William J. Luther, “Dark Dollar Dealings.” U.S. News, 23 February 2015, accessed 25 February 2018, https://www.usnews.com/opinion/economic-intelligence/2015/02/23/us-has-no-business- regulating-bitcoin-because-of-illegal-dealings.
405 “Dotcom Bubble.” Investopedia, January 2018, accessed 22 February 2018, https://www.investopedia.com/terms/d/dotcom-bubble.asp.
JOOSUB 242
Initial coin offerings (ICO) are a new and unregulated way in which funds can be raised for a new blockchain related venture.406 Unlike the expensive and cumbersome regulation required to do a bond issuance or an initial public offering
(IPO), a start-up would simply need to create a detailed whitepaper which acts as a pitch to gain the support of enthusiasts. The start-up indicates a fixed volume of tokens which will then be issued over the internet for a stated price. US dollars or other fiat currencies are then exchanged for the said tokens and the start-up uses the proceeds to begin or continue operations of the scheme in question. Much information on these start-up ventures is typically circulated via blogs, social media or chatrooms. Celebrity endorsements have of late been a popular method of promoting new ICO’s.407 There is little to no neutral third party verification of ICO’s. This form of sensationalist advertising has contributed towards turning the cryptocurrency investment landscape into a mélange of information, not all of which is truthful, relevant or credible.
In the past 18 months, hundreds of new cryptocurrencies have been launched into circulation. According to data on CoinDesk, 2017 saw USD3.5 billion worth of funds raised through ICO’s.408 The main cryptocurrency index Coin Market Cap has a registered total of 1,512 tokens at the time of writing.409 These are tokens that are typically built on the Bitcoin blockchain or another similar protocol. There is no shadow
406 “Initial Coin Offering (ICO).” Investopedia, January 2018, accessed 26 February 2018, https://www.investopedia.com/terms/i/initial-coin-offering-ico.asp.
407 Emmie Martin, “Jamie Foxx, Floyd Mayweather and Other Celebrities Who Are Hyping Cryptocurrencies.” CNBC, 20 December 2017, accessed 25 February 2018, https://www.cnbc.com/2017/12/20/celebrities-who-have-endorsed-or-invested-in- cryptocurrency.html.
408 Nate Lanxon, “Bitcoin Grapples with Age-Old Problem with Inheritance.” Bloomberg Technology, 13 February 2018, accessed 25 February 2018, https://www.bloomberg.com/news/articles/2018- 02-13/bitcoin-industry-grapples-with-age-old-problem-of-inheritance.
409 CoinMarketCap, (2018), op. cit.
JOOSUB 243 of doubt, that this all too easy method of fundraising has been used to prey upon inexperienced investors.410 Cases of fraud, insider trading, and pump and dump scams are unusually high.411 However, investor behaviour indicates that despite being well aware of the fraudulent nature of many ICO’s, FOMO and greed still prevail.
It is not without surprise that regulators around the world are moving to clamp down on the cryptocurrency frenzy. The highest demand for these new tokens is fuelled by South Korea and China, some of the world’s biggest mining hotspots,412 both countries have now moved to ban ICO’s.413 Clampdowns in these markets have increased global volatility of cryptocurrencies in general. At the time of writing, the total market cap of all alternative tokens (alt tokens), including BTC, in circulation is
USD367 billion, down from USD800 billion. Figure 13.a below shows the recent whipsaw in volatility of market caps during the most feverish year of trading, 2017.
Increasing regulation and scrutiny play a huge, if not the only role in the subsequent capricious price movements.
410 Andrew Griffin, “Bitcoin Price: Fraudsters Using Surge in Cryptocurrency to Trick People into Scams.” Independent, 29 January 2018, accessed 25 February 2018, http://www.independent.co.uk/life-style/gadgets-and-tech/news/bitcoin-price-latest-value-scam- fraud-how-to-stay-safe-secure-buy-cryptocurrency-a8183026.html.
411 Oscar Williams-Grut, “Walkthrough: How Traders Pump and Dump Cryptocurrencies.” Business Insider UK, 14 November 2017, accessed 25 January 2018, http://uk.businessinsider.com/how- traders-pump-and-dump-cryptocurrencies-2017-11.
412 Andrew Griffin, “Bitcoin Latest: What Regulation South Korea is Planning and Why it is Hurting Cryptocurrencies’’ Price.” Independent, 16 January 2018, accessed 22 February 2018, http://www.independent.co.uk/life-style/gadgets-and-tech/news/bitcoin-latest-updates-south- korea-trading-ban-regulation-kill-ethereum-prices-cryptocurrency-a8161456.html.
413 Oscar Williams-Grut, “South Korea Bans ICO’s.” Business Insider UK, 29 September 2017, accessed 23 February 2018, http://uk.businessinsider.com/ico-south-korea-bans-icos-2017-9.
JOOSUB 244
Cryptocurrencies by Market Cap (Historical) Coin Dance 2017 - 2018
$600,000,000,000 $500,000,000,000 $400,000,000,000 $300,000,000,000 $200,000,000,000 $100,000,000,000 Market Cap (USD)
$- 1/1/17 2/1/17 3/1/17 4/1/17 5/1/17 6/1/17 7/1/17 8/1/17 9/1/17 1/1/18 2/1/18 10/1/17 11/1/17 12/1/17 Date
Altcoin Market Cap Bitcoin Market Cap
Figure 13.a414
To draw any conclusions about stability or viability on Bitcoin or other cryptocurrencies at this point would be difficult. Aside from the outright fraudulent tokens, there are those with seemingly more attractive protocols than Bitcoin. Litecoin for example, is touted as using a newer ‘Scrypt’ algorithm instead of Bitcoins ‘SHA-
256’ which has typically closed off profitable mining to private individuals without a serious mining infrastructure. Transactions over the Litecoin network also take 2.5 minutes instead of the 10 minutes on the Bitcoin blockchain. Whilst Bitcoin is known as digital gold, Litecoin is sometimes referred to as digital silver. 415
It is important not to split hairs by analysing the different algorithms, hash rates, price movements and other anomalies associated with various cryptocurrencies. The central fact is that digital currencies are the birth of a new ideal in the IMS. When the
414 “Cryptocurrencies by Market Cap (Historical) Summary.” Coin Dance, 23 February 2018, accessed 23 February 2018, https://coin.dance/stats/marketcaphistorical.
415 Jason Fernando, “Bitcoin Vs. Litecoin: What’s The Difference?” Investopedia, 15 February 2018, accessed 23 February 2018, https://www.investopedia.com/articles/investing/042015/bitcoin-vs- litecoin-whats-difference.asp.
JOOSUB 245 total value of all digital currencies topped USD800 billion dollars, that was USD800 billion worth of US dollars, British pounds and other fiat currency not being held in a traditional financial institution. Individual depositors had withdrawn their cash and transferred it into another store of value, which does not require financial intermediation. Cryptocurrencies acted like a sponge which soaked up fiat currency.
Were this trend to continue, demand for national fiat currencies would fall accordingly until those currencies were worth less and less. The liquidity needed by banks to add profitable assets to their balance sheets would likewise be consistently reduced. No such threat to traditional banking has ever existed.
(13.1) New Frontiers
The Tulip bubble, although devastating, was nothing prolific. It did not change the world for the better or worse. The Bitcoin bubble, that is if it is really a bubble indeed, is prolific because by its very existence the current IMS framework is rendered obsolete. The evolution of money has followed the needs of civilization. So far as our contemporary understanding of history goes, Figure 13.b in the table below illustrates the taxonomy of money. JOOSUB 246
Taxonomy of Money Pre-History to Present Day Barter Commodity Commodity Fiduciary Commercial Cryptographic? Backed Bank Date >10000BC ~1100BC ~1290AD ~1661AD ~1694-1912 ~2009AD Substance Objects Metallic Paper Bank Credit, fiat, Blockchain money issued fractional note reserves Value Object of Object of Object of Object of Intangible Intangible object value value redeemable promised object of of attributed value value attributed value value Figure 13.b416,417
Of course the various forms of money are not exclusive to the period in which they developed and have been used concurrently, with the obvious exception of blockchain currencies. They also all share similarities, such as fungibility, durability, cognoscibility, portability and a degree of stability.418 As for cryptographic currencies, their practicability thus truly remains dependent on the needs of civilization at this point in time. These pressing needs were first alluded to at the very beginning of this study.
An article in Business Insider confirms what the most severe of these issues are, in decreasing order of imminence:419
1. Climate change and desolation of natural resources
2. Large scale conflict
416 Rebecca Burn-Callander, “The History of Money: From Barter to Bitcoin,” The Telegraph, 20 October 2014, accessed 20 February 2018, https://www.telegraph.co.uk/finance/businessclub/money/11174013/The-history-of-money- from-barter-to-bitcoin.html.
417 Andrew Beattie, “The History of Money: From Barter to Banknotes.” Investopedia, 29 December 2015, accessed 17 February 2018, https://www.investopedia.com/articles/07/roots_of_money.asp.
418 Jeff Desjardins, “Infographic: The Properties of Money.” Visual Capitalist, 15 December 2015, accessed 25 February 2018, http://money.visualcapitalist.com/infographic-the-properties-of-money/.
419 Abbey Jackson, Tanza Loudenback, “The 10 Most Critical Problems in the World, According to Millennials,” Business Insider UK, 26 February 2018, accessed 26 February 2018, http://uk.businessinsider.com/world-economic-forum-world-biggest-problems-concerning- millennials-2016-8?r=US&IR=T/#6-safety-security-and-well-being-181-5.
JOOSUB 247
3. Poverty and rising inequality
4. Government transparency and corruption
When trying to identify a common cause synonymous with all of the above criticalities, it is generally best practice to avoid hasty conclusions. However, author
Robert Frank was not incorrect when he posited that economics can variously explain all but anything.420 An accumulation of systematic issues in the structural framework of the IMS has contributed to the aforementioned major fissures in our civilization. As a result, nine contributing factors were addressed at length in the body of the study, all of which this study proved are common causes to the fissures we are currently being experienced in the foundations of our society. They were; money, debt, capital adequacy, CRA’s, accounting principles, shadow banking, derivatives, too-big-to-fail banks, and proprietary trading. The proposed recommendation to reducing the systematic volatility in the IMS was a bimetallic SDR coupled with an ethical framework that culminated in the IFC. By reducing or annihilating the structural flaws and thus the dangerous systematic volatility, equilibrium can be restored to the global economy. It is then assumed that the mutually beneficial global circumstances will in turn alleviate the criticalities highlighted at the beginning of this research endeavour and by Business Insider.
With the effective use of blockchain and digital currencies, it is entirely possible that all types of volatility, i.e. systematic, economic and political, can become a worry of the past. A technological advancement such as blockchain is just the catalyst needed to hold corporations responsible, to prevent economic favouritism, to bank the
420 Robert H. Frank, The Economic Naturalist: Why Economics Explains Almost Everything (Virgin Books, 2008). JOOSUB 248 unbankable and to make corruption in governing echelons impractical. Examples were previously alluded to with regards to government elections that could all be hosted by a blockchain, or land and automotive registries. providing full and unalterable histories of all assets. For the purposes of this epilogue, monetary changes are of particular relevance, even if they represent just one slice of the blockchain revolution.
(13.2) Déjà Vu
Blockchain and cryptographic currencies may be new potentials in the world of exchangeable value, but their concept is by no means new. The Bancor, French for
‘bank gold,’ was first conceptualized by Keynes between 1940 and 1942.421 It was a theorized supranational unit of account, belonging to no particular nation, it was exchangeable for gold and it required a multilateral clearing system which was the seriously considered but never adopted International Clearing Union (ICU).
A currency like Bitcoin takes the same concept even further. For the instances of this analysis it is merely a case study, as newer or better digital currencies are likely to reveal themselves as the distributed ledger matures. Yet it bares the correct characteristics for now. It is supranational, removing any national biases. It is currently not exchangeable for any physical commodity but its supply is controlled by a protocol that allows for a maximum release of 21 million Bitcoins. Finally, Bitcoin is completely decentralized, relying on no third party for clearance or verification. This final point would remove the need for the ICU proposed by Keynes since the P2P nature of the distributed ledger ensures that all nodes on the network fulfill the responsibilities of verification and clearance.
421 Benn Steil, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order (Princeton: Princeton University Press, 2013), p. 143.
JOOSUB 249
The Bancor was conceived because Keynes believed, at a time when national control of capital movements was a top national security concern, that economies needed a better way of tracking international flows of assets and liabilities. All trade was to be valued and cleared using Bancor, but individuals would be unable to hold or trade Bancor like a commodity.422 Bancor’s would have been redeemable for gold, which is finite and has steady annual production, but Keynes did not mention any restrictions on the ICU from simply creating more Bancor relative to gold should the need arise. It is at this point that a digital currency like Bitcoin shows its superiority.
Unlike the Taylor rule or the k-percent rule, the Bitcoin blockchain protocol would provide for a feasible and more stable monetary policy without constant interruption by the state. Figure 13.c below indicates a 100-year projection of the
Bitcoin release rate based on a reward halving rate of approximately every four years.
Approximate Release Rates of BTC Relative to Future Blocks Added 100 Year Projection
25,000,000.00
20,000,000.00
15,000,000.00 BTC/Block 10,000,000.00 Blocks Added Release Rates 5,000,000.00 BTC Added
0.00 Total BTC 1/1/2009 1/1/2015 1/1/2021 1/1/2027 1/1/2033 1/1/2039 1/1/2045 1/1/2051 1/1/2057 1/1/2063 1/1/2069 1/1/2075 1/1/2081 1/1/2087 1/1/2093 1/1/2099 1/1/2105 1/1/2111 1/1/2117 Date
Figure 13.c423
422 Benn Steil, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order (Princeton: Princeton University Press, 2013), p. 143-144.
423 Blockhalf, (2018), op. cit.
JOOSUB 250
As mentioned previously, the production of Bitcoin follows a convex asymptote.
Block rewards are halved every 210,000 thousand blocks, or every four years, reflected by the yellow line in Figure x. The grey line indicates the consistently reduced release of Bitcoin over time, which is positively correlated to the reducing addition of Bitcoin to the total balance already in circulation.
Recent calls to revisit the adoption of the Bancor were further detailed in chapter
2 above of the main study,424 other substitutes as a reserve asset were also explored, such as the IMF’s SDR. The next section of this epilogue will take a closer look at how a digital currency could be used in a way that may transcend the use of US dollars, gold the SDR or the Bancor. The reference to the Bancor was made with regards to Bitcoin because they are similar in that they are both pioneers of a better conceptual monetary mechanism in the IMS. Yet much like how the first car ever invented was not a perfect means of transport, it was still an advancement on the horse.
(13.3) Theoretical Justifications
First the ambitious nature of this analysis needs to be clear. The aforementioned global criticalities which require immediate diffusion are related without a doubt to severe economic imbalances. These imbalances have arisen because of structural economic flaws that have been repeatedly dealt with inadequately. Thus, the IMS has entered new territory which is best described as permanent volatility.425 The future horizon is littered with ‘Black Swan’ events, anyone of which could trigger a market
424 Xiaochuan, (2009), op. cit.
425 Michael Yoshikami, “Permanent Market Volatility, Connectivity, Globalization, and Synchronized Panic.” National University of Singapore Business School, (2012), accessed 20 February 2018, https://bschool.nus.edu.sg/Portals/0/images/CAMRI/Thought%20Leadership/Permanent- Market-Volatility-Connectivity-Globalization-and-Synchronized-Panic-Michael-Yoshikami.pdf.
JOOSUB 251 crash or large scale conflict because the needed resilience and mutual cooperation in the
IMS has been worn away by zero-sum game competing interests and poor monetary policy.426
The birth of blockchain, a phenomenon as major as the birth of the internet in
1990, can create a transparent world where the need for third party trust is removed. The solution to the ‘trust’ problem has far-reaching consequences, social, economic and political. It is the position of this study that one particular aspect of the blockchain, digital currency, has the potential to best adapt the IMS for the changing needs of this era of mankind.
The Austrian business cycle theory (ABCT) is a component of the Austrian school of economics, and it was developed by Ludwig von Mises and Friedrich von
Hayek, the latter having won a Nobel Memorial Prize in Economic Sciences for his contributions.427 It explains that unsustainable periods of low interest rates and inflationary easy credit, much like what has been witnessed since the financial crisis in
2007, are responsible for three major issues;428
1. Troughs of unemployment
2. Idle resources
3. Volatility in savings and investment
426 Ariel Cohen, “The ‘Primakov Doctrine:’ Russia’s Zero-Sum Game with The United States.” The Heritage Foundation, (1997), accessed 23 February 2018, file:///Users/Hassaan/Downloads/fyi167.pdf.
427 “The Prize in Economics 1974 – Press Release.” Nobelprize.org, 9 October 1974, accessed 23 February 2018, https://www.nobelprize.org/nobel_prizes/economic- sciences/laureates/1974/press.html.
428 Woods, Jr., Thomas, "22: Did Capitalism Cause the Great Depression?" 33 Questions about American History You're Not Supposed to Ask. New York: Crown Forum, (2007): pp. 174–179.
JOOSUB 252
As a result, Hayek clarifies that the origin of instability and market cycles is a monetary one.429 The ongoing QE programs, when stopped, threaten to create deep unemployment, idle resources and even more capital volatility. Keynes on the other hand, opposed this view and attributed highs and lows in the business cycles to effective demand. However, evidence of QE’s lack of effectiveness was further detailed in chapter 4 of the main study, accordingly, it is Hayek’s view from the ABCT which justifies the theoretical application of blockchain currencies which have the protocols needed for stable monetary policy.
A further justification of the much-needed benefits of a blockchain economy and a blockchain based monetary system can be seen when looking at the pitfalls of a centrally planned economy. Unlike a capitalistic free market economy, where prices and demand and supply are completely influenced by individuals in the market, the centrally planned economy can be described as more socialist or communist.430 There is a designated central authority, or a government, that makes all of the economic decisions rather than interactions between consumers and businesses. It is the prevailing perspective that most developed countries reflect a model akin to a mixed economy, which is a balance of market shaping forces between the private and government sectors.431
Nevertheless, there is mounting evidence to suggest that excessive government regulation and intervention, in not only the business sector, but also in monetary and
429 Heinz D. Kurz, Critical Essays on Piero Sraffa’s Legacy in Economics, (Cambridge University Press, 2000): 7.
430 “Centrally Planned Economy.” Investopedia, January 2018, accessed 12 February 2018, https://www.investopedia.com/terms/c/centrally-planned-economy.asp.
431 “A Mixed Economy: The Role of the Market.” U.S. Department of State, (2005): accessed 30 January 2018, https://www.colorado.edu/AmStudies/lewis/ecology/mixedeconomy.pdf.
JOOSUB 253 fiscal policy is creating economies that no longer meander with free market forces.
Hayek knew that tampering with ‘money’ in the free market mechanism creates instability and cycles in a free market economy. In fact, it ceases to be a free market economy at all because monetary policies are not only centrally planned and drafted, by central banks and treasury departments, but they are possibly the deepest most absolute form of market control. In his book Prices and Production, Hayek came under fierce criticism from his peers for his theories. Many of his contemporaries ceased to look at him with any credibility thereafter, with Milton Friedman declaring his respect for
Hayek but conceding that this portion of his work is “very flawed.”432
Hayek’s monetary explanation to the origins of the cycle are best described in a quote from Prices and Production;433
The past instability of the market economy is the consequence of the exclusion
of the most important regulator of the market mechanism, money, from itself
being regulated by the market process.
In other words, the regulation of money is best left to free market forces.
Although, in chapter 3 of the main study, the SDR and a gold standard were examined for their potential uses and benefits in the IMS. The conclusion of the study suggested a bimetallic SDR as a new supranational reserve unit of account. Additionally, there was an ethical framework laid out in the IFC: gold was the guarantee for the SDR, redeemable and finite.
432 Roger W. Garrison, “In Defence of Hayek’s ‘Technical Economics.’” LSE Hayek Society Journal, Volume 5, no. 2, (2003): accessed 28 January 2018, http://www.auburn.edu/~garriro/amagi.htm.
433 Friedrich A. Hayek, Prices and Production, (Augustus M. Kelly Publishers, New York, 1931), 69.
JOOSUB 254
The finite nature of gold or digital currencies is what separates them from the
Keynesian notions of the Bancor. As a matter of fact, Keynes was again vehemently opposed to the decision made by Winston Churchill to revert to the gold standard in
April of 1925. Keynes went so far as to write several essays and flyers denouncing the move.434 Hayek on the other hand, thought that gold or a ‘bundle of commodities’ would be the solution to reducing the cyclicality in markets, moreover, they are more conducive to the notion of free markets.435 Unfortunately, there were problems after
Churchill’s golden decision and many gold bug economists claimed that it went so far as to deepen the Depression. Conversely, in chapter 3 of the main study, it was shown that protectionist American tariff policy, poor gold pricing as well as the need to print more money for WWII was the real reason the gold backed system failed. Even in today’s age, despite the advantages of a supranational and predictable unit of account, the prevailing view is still one that views gold as draconian in nature.436
In a 2018 interview at the Sustainable Finance Lab in Amsterdam, chief economic commentator of the Financial Times (FT), Martin Wolf, outlines four points concerning the fundamentals of monetary policy;437
434 James Titcomb, “How the Bank of England Abandoned the Gold Standard.” The Telegraph, 7 January 2015, accessed 27 February 2018, https://www.telegraph.co.uk/finance/commodities/11330611/How-the-Bank-of-England- abandoned-the-gold-standard.html.
435 Tyler Cowen, “Hayek on the Gold Standard and Commodity Reserve Currency.” Mr University, January 2016, accessed 12 February 2018, https://www.mruniversity.com/courses/great- economists-classical-economics-and-its-forerunners/hayek-keynes-debate-gold-standard- monetary-policy.
436 Kimbery Amadeo, “What is the Gold Standard?” The Balance, 25 April 2017, accessed 14 February 2018, https://www.thebalance.com/what-is-the-gold-standard-3306137.
437 “Campaign for Monetary Reform – News from Switzerland.” Vollgeld Initiative, 15 February 2018, accessed 15 February 2018, https://www.vollgeld-initiative.ch/english/. JOOSUB 255
First of all, the main message that we need to be aware of is that we have first
just lived through an enormous financial crisis, probably the biggest financial
crisis ever, which has had enormous and devastating effects. Most people hope
that we are not going to have anything like this ever again. The second point is
that while we have had a great deal of regulatory activity, immensely complex
and difficult regulatory activity agreed across the world, in essence the system
remains the same. The risks in it are not fundamentally different, they are only
possible managed better. Above all, we mistrust finance so profoundly that the
solution we have found is not to create a market led system but rather to have
officials and administrators make pretty much all of the decisions in the financial
sector. So we have a really perverse situation whereby we supposedly have a
market driven economy but we do not have market driven finance, particularly
in banking. The third point is that if we want this to be different we have to
create a different system. The starting point is to recognize that the reason we
cannot leave banking to be an ordinary business is that it is responsible, directly,
for creating nearly all of the money in our economy as a result of its lending
activity. We simply cannot allow a monetary collapse. It is not something that is
possible for any government to permit. So beyond a certain point, banking
institutions know that they are fundamentally going to be rescued. As a result of
that, they are going to take huge risks and sooner or later the system will blow
up and they will use their resources to lobby for lighter regulation. With Mr.
Trump elected that could happen quite soon! So we have got to think of a more
radical alternative. My fourth main point is the alternative, it is that governments
again take control of the creation of money as a means of payment and store of
value which is absolutely certain and solid. That allows the rest of the financial JOOSUB 256
system to become more genuinely market led and market driven with the risks
internalized within it. These are the central points I believe people need to
understand.
Wolf had lost many relatives in the Holocaust and thus his background had made him cautious of political extremes. This peaked his interest in economics because he felt that poor economic policy was one of the root causes to WWII.438 With regards to giving control of the money creation back to the government, the Vollgeld Initiative in Switzerland is a near future vote which proposes just that. It was alluded to in chapter
2 and 3 of the main study and is not too dissimilar from Wolf’s ideas. This initiative, which will go to the Swiss polls in June 2018, would give back the creation of money to the SNB and take away the creation of credit from commercial banks. Ideas for a cryptographic, locally denominated, central bank money have also been entertained by
Thomas Jordan, SNB Chairman.439 This latter idea will be explored more deeply in a later section of the epilogue when the concepts of digital currency are applied to the conclusions in the main body of research.
(13.4) In Defence of Easy Money
Recent history allows for the drawing of conclusions on when and why gold proved to be an inconvenient monetary policy. This is crucial because the idea of
‘digital gold’ may prove to be equally inconvenient, especially because of the
438 Julia Ioffe, “Call of the Wolf.” The New Republic, 16 September 1009, accessed 28 February 2018, https://newrepublic.com/article/69326/call-the-wolf.
439 Thomas J. Jordan, “How Money is Created by the Central Bank and the Banking System.” Swiss National Bank, (2018): accessed 24 February 2018, https://snb.ch/en/mmr/speeches/id/ref_20180116_tjn/source/ref_20180116_tjn.en.pdf.
JOOSUB 257 transparency a distributed ledger offers. Two use cases were in 1939 in the United
Kingdom and 1973 in the United States respectively, both economies pulled off the gold standard at those respective times. Both nations were at war, WWII and the Vietnam
War respectively. Chapter 1 explains that without a doubt, in both instances money was needed and printed to finance the campaigns. The incremental additions of gold to the money supply would simply not allow for that. It can be deduced that fiat currencies and easy money policy seems to be the best facilitator of war. With the likes of QE as well as easy access to capital markets, the existing state of global monetary policy allows for even more easy credit than was available during both WWII and Vietnam combined.440
Rather than large-scale conflicts, notwithstanding their current probability or possibility, most major economies have historically high military expenditure. Figures
13.c and 13.d below offer a snapshot of the nations with leading military expenditure.
440 “The Cost of U.S. Wars Then and Now.” War History Online, 5 October 2016, accessed 28 February 2018, https://www.warhistoryonline.com/war-articles/wwii-bomber-pilot-recounts- harrowing-first-mission-x.html.
JOOSUB 258
Top 15 Countries Global Military Expenditure 2016 Forbes & Statista
Israel UAE Brazil Australia Italy South Korea Germany Japan
Country United Kingdom France India Saudi Arabia Russia China United States
$- $100 $200 $300 $400 $500 $600 $700 Spending
Figure 13.c441
441 Niall McCarthy, “The Top 15 Countries for Military Expenditure in 2016,” Forbes, 24 April 2017, accessed 15 February 2018, https://www.forbes.com/sites/niallmccarthy/2017/04/24/the-top- 15-countries-for-military-expenditure-in-2016-infographic/#7596d36f43f3.
JOOSUB 259
Percentage Share of Total Global Military Expenditure 2016 Forbes & Statista
Israel UAE Brazil Australia Italy South Korea Germany Japan United Kingdom
Country France India Saudi Arabia Russia China United States
0% 5% 10% 15% 20% 25% 30% 35% 40% Percentage
Figure 13.d442
Current global military expenditure is massively bloated. Chapter 6 of the main study above best illustrates the skewed budgets of some major economies for further comparison, the numbers tell a chilling story. Certain special interest groups will consistently lobby for easy credit,443 under the pretext that nothing could be better for the economy. Ironically however, militaries tend to reduce economies to rubble.
How are these loose military budgets justified? Today, terrorism and North
Korea are listed as hostile and aggressive, amongst a host of other threats which are all pertinent reasons for governments to rationalize these numbers.444 It is not at all the
442 McCarthy, (2017), op. cit.
443 “Defence: Top Contributors, 2017-2018.” Open Secrets, January 2018, accessed 10 February 2018, https://www.opensecrets.org/industries/indus.php?Ind=D.
444 “Conclusion: Global Threat Level.” The Heritage Foundation, January 2018, accessed 27 February 2018, https://index.heritage.org/military/2017/assessments/threats/conclusion-global-threat- level/. JOOSUB 260 view of this study to deny or minimize legitimate national security threats, this analysis only serves in suggesting why monetary policy is the way it is. Moreover, it serves in suggesting which parties most benefit from the cheaper money and hence which parties may be most agitated by the proposed changes to monetary policy. Therefore, the monetary changes a digital currency offers, much like gold did, may ruffle the feathers of the military-industrial complex, who would have a harder time procuring lucrative government contracts without their primary customers having access to easier credit.
It is thus predicted that a change in the monetary policy, whereby money creation is decentralized, traceable and more finite, will invariably lead to some parties framing it as a social, political and economic ‘danger.’ Be that as it may, would a new digital currency regime actually pose a genuine threat towards the global fight against terrorism and tyrannical regimes? The data does not lie. Figure 13.e below shows domestic statistics concerning the country with the largest annual military budget, the
United States.
JOOSUB 261
Deaths by Gun Violence vs. Terrorism (2001-2014) Centers for Disease Control and Prevention, US State Department
35,000
30,000
25,000
20,000 Deaths by Gun Violence 15,000 (440,095) 10,000 Deaths by Terrorism (3,412) Number of Casualties 5,000
0 1/1/01 1/1/03 1/1/05 1/1/07 1/1/09 1/1/11 1/1/13 Date
Figure 13.e445
The information displayed above may indicate that the pretexts behind defence budgets are not entirely correlated with the reality of day-to-day threats. Terrorist related deaths are more than one hundred times lower than domestic gun violence. The disproportion in the figures cannot feasibly rationalize such a high allocation of the national budget to defence. Albeit, a terrorist related death is a death nonetheless and is a grave national security concern. It no doubt warrants a proportionate response. Yet, the figures from the US State Department seem to indicate that practical national interests demand more emphasis on gun control safety rather than on F-35 fighter planes and M1 Abrams battle tanks.
This research does not take any political stances; it remains purely academic.
Yet, in order to defend this study from the criticism it may invite, further understanding is offered in Figure 13.f below, which shows causes of death based on highest to lowest likelihood in the United States.
445 Eve Bower, “American Deaths in Terrorism Vs. Gun Violence in One Graph,” CNN, 3 October 2016, accessed 13 February 2018, https://edition.cnn.com/2016/10/03/us/terrorism-gun- violence/index.html. JOOSUB 262
Lifetime Odds of Death Based on Event 2015 Averages National Safety Council, National Centre for Health Statistics, Cato Institute, Tulane University Cause of Death Lifetime Cause of Death Lifetime Odds Odds Heart disease 1 in 7 Choking on food 1 in 3,409 Cancer 1 in 7 Bicycling 1 in 4,337 Any Injury 1 in 21 Accidental gunshot 1 in 7,945 Chronic lung disease 1 in 27 Police 1 in 8,359 Accidents 1 in 31 Airplane/spaceship incidents 1 in 9,738 Stroke 1 in 31 Heat wave 1 in 10,785 Alzheimer’s disease 1 in 47 Electricity/radiation/heat/pressure 1 in 14,697 Diabetes 1 in 53 Animal attack or accident 1 in 30,167 Influenza/pneumonia 1 in 70 Sharp objects accident 1 in 30, 863 Kidney disease 1 in 85 Foreign born terrorist 1 in 45,808 Suicide 1 in 98 Tornado 1 in 60,000 Any motor vehicle accident 1 in 113 Cataclysm storm 1 in 63,685 Falling 1 in 133 Asteroid (global impact) 1 in 75,000 Murder 1 in 249 Legal execution 1 in 111,449 Assault by gun 1 in 358 Dog attack 1 in 114, 634 Car/van/truck incidents 1 in 565 Earthquake 1 in 130,000 Suffocation 1 in 608 Bus, train or streetcar 1 in 160,487 Walking 1 in 672 Lightning 1 in 174,443 Motorcycle 1 in 949 Stinging by hornets/wasps/bees 1 in 308,629 Drowning 1 in 1,183 Asteroid (regional impact) 1 in 1,600,000 Poisoning (liquid/gas/solid) 1 in 1,355 Shark attack 1 in 8,000,000 Fire or smoke 1 in 1,454 Refugee terrorist 1 in 46,192,893 Assault by sharp object 1 in 2,448 Illegal immigrant terrorist 1 in 138,325,873 Any force of nature 1 in 3,122 Figure 13.f446
To give the statistics more perspective, instead of being killed by a foreign born, refugee or immigrant terrorist, the average American is 13 times more likely to choke on food, 407 times more likely to be involved in a fatal car accident, 867 times more likely to die of diabetes or 6,571 times more likely to die of another heart related disease.
With the theoretical cross-section of a digital currency applied to recent monetary policy, it consequently remains to assess how Bitcoin or other digital currencies have been projected to integrate into the IMS. Much of this integration is
446 Skye Gould, Dave Mosher, “How Likely Are Foreign Terrorists to Kill Americans? The Odds May Surprise You,” Business Insider UK, 1 February 2017, accessed 26 February 2018, http://uk.businessinsider.com/death-risk-statistics-terrorism-disease-accidents-2017- 1?r=US&IR=T. JOOSUB 263 difficult to assess at this point and may indeed be inaccurate, as such an unpredictable phenomenon would be best ordered in hindsight. Developments in the field of blockchain happen so sporadically that they scarcely have a chance to be documented and analysed. Yet, in preparing to analyse the most fruitful outcome for digital currencies in relation to the reduction or even removal of systematic risk, it is necessary to take an academic purview of all potentials.
Hayek and Wolf essentially took the stance of refusing to acknowledge that trial and error monetary policy was the best we can do and thus, systematic risk and cycles are an inevitable reality. Though this stance may be somewhat naïve, it is more brave and will produce better economic policy than the Keynesian Bancor, which was a tepid remedy in the face of the throbbing need for structural reforms.
(13.5) Seven Habits of a Highly Effective Bitcoin
There are still many unresolved issues with blockchain technology. Basic factors of production such as skilled labour, machinery and legitimate blockchain organizations are few and far between.
It is however still possible to theorize what the IMS would look like were it to run on blockchain technology. As was previously explained in chapter 1 above,
‘Reducing Systematic Risk with an International Financial Code,’ looks closely at the hypothetical use of a bimetallic SDR coupled with the IFC amid the objective of reducing systematic risk in the IMS. The previous research provides a sound foundation upon which to introduce the concept of a digital currency. Blockchain is currently popularly associated only with its uses as money, it does however have universal applications which were touched upon previously. To look at it in isolation only does it JOOSUB 264 partial justice, but enough of a picture can be drawn so as to understand the potential benefits to the IMS of its application to monetary policy.
Trace Mayer, early Bitcoin investor and host of the Bitcoin Knowledge Podcast, gave an interview in January 2018 where he described the proliferation of Bitcoin using the ‘network effect.’ Mayer’s explanations of Bitcoin’s geopolitical and monetary significance are helpful in determining the use case of any future digital currency and its path to worldwide acceptance. In total, there are seven network effects in the foreseeable lifespan of Bitcoin. They are described as follows;447
1. First network effect, speculation. Individuals in the market collect Bitcoin
much like how silver, gold and tulips were collected because of anticipated
appreciation in value.
2. Second network effect, accepted means of payment. As a result of accumulated
Bitcoin with individuals as a store of value, merchants begin acceptance of
Bitcoin as a means of payment.
3. Third network effect, merchant usage. As a variety merchants accumulate
Bitcoin on their balance sheets, they begin settling their dues with suppliers in
Bitcoin.
4. Fourth network effect, miners add increasing security. As more users demand
Bitcoin, the price is driven upwards. Accordingly, the block reward for miners is
more lucrative. That in turn incentivizes more miners to join the network and
add even further security.
447 Valentin Schmid, “Trace Mayer: Bitcoin Can Become A Reserve Asset,” The Epoch Times, 19 January 2018, 9 February 2018, https://www.theepochtimes.com/trace-mayer-Bitcoin-can- become-reserve-asset_2418481.html. JOOSUB 265
5. Fifth network effect, More blockchain development. As a result of more miners
adding to the networks security, the Bitcoin blockchain attracts more
development. This could be new developers seeking to refine the protocol or
other companies wanting to build on the blockchain protocol because of its
perceived safety and immutability.
6. Sixth network effect, financialization. This is manifested in the creation of
financial products around Bitcoin. Some examples are futures contracts on the
Chicago Mercantile Exchange (CME) or on the Chicago Board Options
Exchange (CBOE) respectively.
7. Seventh network effect, reserve currency status. With increasing
financialization, Bitcoin because more integrated in the IMS and its presence is
felt everywhere. At this point, it is declared a reserve currency by major central
banks and governments at which point it is stockpiles along with gold and other
platinum group metals.
In using Bitcoin as a proxy for what it or another similar cryptographic currency may achieve in the IMS in the near future, Mayer leaves some wide and obvious gaps in his predicted path ahead based on the seven network effects.
Bitcoin has proven its ascension through the network effects up until effect six.
Yet even in the preceding effects it would be difficult to suggest that Bitcoin had reached 100 percent saturation of each respective effect. For example, despite use amongst individuals and merchants, Bitcoin still only represents a tiny proportion of the overall currency market. Roughly USD8.2 billion worth of Bitcoin are traded daily,448
448 CoinMarketCap, (2018), op. cit.
JOOSUB 266 whereas USD5.3 trillion worth of other national currencies move through forex markets in the same amount of time.449 For added perspective, total global currency in circulation is estimated at USD215 trillion, with about a third of it being debt.450 On the other hand, at the time of writing, Bitcoins market cap is USD194 billion. Its continued price resilience shows consistent and ever increasing demand, which is a positive sign.
However, it remains a desperate victim of regulatory whims, which seem able to make or break its success.
Indeed, the CME Group has added Bitcoin derivatives to the equation, but that is only best described as a taste of financialization. Moreover, investor responses to these futures has been described as weak.451 The sixth network effect as outlined by Mayer still has a long way to go, it would only be truly realized once Bitcoins volatility can influence global markets. This would be a proverbial sign of playing in the big leagues, so to speak.
With regards to becoming a reserve asset, Mayer is short of many considerations. Amongst the many requirements a government has before stocking a reserve asset, the asset needs to be in the least considered a hard currency or a safe- haven currency. Bitcoin is neither. In 2010, a report released by the United Nations
Conference on Trade and Development (UNCTD) called for an abandoning of the US
449 Gregory McLeod, “Forex Market Size: A Traders Advantage.” Daily FX, 24 January 2014, accessed 20 February 2018, https://www.dailyfx.com/forex/education/trading_tips/daily_trading_lesson/2014/01/24/FX_Ma rket_Size.html.
450 Sue Chang, “Here’s All the Money in the World, in One Chart,” Market Watch, 28 November 2017, accessed 12 February 2018, https://www.marketwatch.com/story/this-is-how-much-money- exists-in-the-entire-world-in-one-chart-2015-12-18.
451 “CME Bitcoin Futures Demand Weak, Ethereum Notches Record,” Investing.com, 18 December 2017, accessed 24 February 2018, https://www.investing.com/news/cryptocurrency- news/Bitcoin-futures-demand-on-cme-subdued-ethereum-notches-record-1005553.
JOOSUB 267 dollar as a global reserve asset in an effort to create a more stable IMS.452 This does not entail that Bitcoin could necessarily qualify, even in the face of many state and private actors calling for monetary reform. It has thus far proven to be volatile and imbued with uncertain prospects. This could of course change. Although, for central banks and governments to change the composition of their required reserves, a remarkable paradigm shift would need to be accompanied by an equally remarkable development in the digital currency arena.
(13.6) Geopolitical Tension
Mayer Makes an interesting observation with regards to the different strategic moves aroused by international actors as a result of developments in digital currencies.
At least since the end of the Bretton Woods regime, there have no doubt been changes brewing beneath the surface of the existing US dollar denominated fiat regime. This is nothing new, since recent analyses by James Rickards were cited in the main study, especially chapter 3, which clearly illustrated examples of currencies, financial markets, commodities and gold in particular being used by nations as geopolitical weapons.
Therefore, it is no surprise that Bitcoin will be leveraged accordingly by players in the strongest position to benefit from it.
For example, Mayer points out that in August 2017, the Bitcoin protocol had a much delayed software update called Segregated Witness (SegWit). This was a concept developed by Dr Pieter Wuille, a Bitcoin core developer responsible for many other improvements to the Bitcoin network through his open source software development
452 Louis Charbonneau, “Scrap Dollar as Sole Reserve Currency: UN Report,” Reuters, 29 June 2010, accessed 27 February 2018, https://www.reuters.com/article/us-dollar-reserves-un/scrap-dollar- as-sole-reserve-currency-u-n-report-idUSTRE65S40620100629.
JOOSUB 268 platform, Blockstream.453 This update removed certain data from each block thereby freeing up space to allow for added transactions. Instead of the allowed 1 megabyte per block SegWit gives each block just under 4 megabytes of space.454 This would in turn speed up processing times and allow for greater development on the Bitcoin network.
Just four months after this development to the Bitcoin protocol, the BRICS group of countries announces its intention via the 10th Russian Bullion Market conference to create their own bilateral gold trading system.455 Sergey Shvetsov, First
Deputy Chairman of Russia’s Central Bank also went further in his declarations by negating the traditional dominance of London and Switzerland in gold markets. By stressing their increasing irrelevance in today’s IMS, Shvetsov also alluded to new gold pricing benchmarks which would materialize as a result of BRICS bilateral cooperation.
China, Russia and South Africa are in the top 10 global gold producers,456 Accordingly,
BRICS nations stand to benefit the most from increasing use of gold and upwards price movements of gold.
Mayer then indicates that only one week after this gold play by the BRICS nations, the CME and CBOE Groups decide to launch Bitcoin futures contracts. This move towards the greater financialization of Bitcoin was much deliberated by Western regulators who had previously cited many complications causing delays.457
453 “Rethink Trust.” BlockStream, January 2018, accessed 26 February 2018, https://blockstream.com/.
454 “SegWit (Segregated Witness).” Investopedia, January 2018, accessed 31 January 2018, https://www.investopedia.com/terms/s/segwit-segregated-witness.asp.
455 Ronan Manly, “Russia, China, India Unveil New Gold Trading Network,” Zero Hedge, 12 March 2017, accessed 1 March 2018, https://www.zerohedge.com/news/2017-12-02/russia-china-india- unveil-new-gold-trading-network.
456 “Gold Mining Map.” World Gold Council, January 2016, accessed February 28 2018, https://www.gold.org/about-gold/gold-supply/gold-mining/gold-mining-map.
457 Rakesh Sharma, “Four Problems with Bitcoin Futures.” Investopedia, 8 December 2017, accessed 20 February 2018, https://www.investopedia.com/news/four-problems-Bitcoin-futures/. JOOSUB 269
Mayer has offered to suggest that Russia and China, the pioneering forces behind the new gold trading system, may be making a move based on the fact that
United States gold reserves may in fact be a myth.458 Therefore, returning to the historical anchor of gold is not a viable solution for the United States as they ponder new global monetary policy and structural reforms. Whereas with Russia and China, it is no secret that their combined gold holdings are formidable in comparison with the
U.S., this is outlined in more detail in chapter 8. Their logical move is therefore to propose an international trading system based on gold, being supranational, stable and finite. The U.S. on the other hand, could be leveraging their position of technological innovation and Mayer suggests that the mysterious origin of Bitcoin is actually
American. There is no shortage of conspiracy theories alluding to Bitcoin being the brainchild of Silicon Valley, the National Security Agency (NSA) or the CIA.459
Although it seems reasonable to suggest that the origins of Bitcoin have been intentionally kept secret so that it remains supranational, at least only in appearances.
Mayer who is a strong advocate of the universal proliferation of Bitcoin, believes that this countermove by the U.S. will ultimately prevail over the stance held by the BRICS. As blockchain development is currently attracting the best and the brightest talent from the world of computer scientists, it is therefore bound to overcome regulatory and protocol related issues and reach the seventh network effect of reserve currency status. China and Russia on the other hand, have dramatically increased gold
458 Alister Bull, “Mnuchin’s Fort Knox Quip: I Assume the Gold is Still There.’” Bloomberg Quint, 22 August 2017, accessed 20 February 2018, https://www.bloomberg.com/news/articles/2017-08- 21/mnuchin-to-visit-fort-knox-assumes-america-s-gold-still-there.
459 Ethan Huff, “Bitcoin Created by the CIA and NSA, Warns Cofounder of Kaspersky Security Software Firm.” Natural News, 31 January 2018, accessed 22 February 2018, https://www.naturalnews.com/2018-01-31-Bitcoin-created-by-the-cia-and-nsa-warns-co- founder-of-kaspersky-security-software-firm.html.
JOOSUB 270 purchases, as pointed out in chapter 8 and have even encouraged their population to keep gold in a ‘storing gold by the people’ program.460 The Asian clamp down on cryptocurrencies can now also be viewed from a different angle.
Moreover, in a September 2014 speech delivered at the launching ceremony of the International Board of the Shanghai Gold Exchange (SGE), Chinese Central Bank
Governor, Zhou Xiaochuan, explained that the launch of the International Board of the
SGE would aid in the facilitation of the price discovery function in the gold market.461
Xiaochuan has made clear the intention of the Chinese to move the current price discovery away from the Commodity Exchange, Inc. (COMEX) in Chicago to a RMB denominated discovery function at the SGE. There is even the widespread belief that
China’s real gold acquisitions far exceed what is popularly noted by the World Gold
Council’s (WGC) statistics.462 The WGC is widely seen as an authority on statistics concerning gold and its data is cited by most credible news outlets. The disinformation would explain the relatively flat recent gold price in lieu of increasing purchases by
China, which may actually be 23 percent or more than reported.
The geopolitical war is currently a race to establish a new monetary basis for the
IMS. The contenders are cutting edge technology in one corner and gold in another.
Both parties are playing with the tools at their disposal and both parties are not doing anyone any favours. It is entirely possible that the next emerging monetary system,
460 William Middelkoop, “Chinese Has a Program ‘Storing Gold by the People,’ But Don’t Want You to Know.” The Big Reset, 6 March 2016, accessed 2 March 2018, http://www.thebigresetblog.com/index.php/chinese-central-bank-has-a-program-called-storing- gold-by-the-people/.
461 Zhou Xiaochuan, “Governor Zhou Xiaochuan Attended Launch Ceremony of International Board of Shanghai Gold Exchange.” The People’s Bank of China, 18 September 2014, accessed 25 February 2018, http://www.pbc.gov.cn/english/130721/2808463/index.html.
462 Koos Jansen, “How the World is Being Fooled by Chinese Gold Demand.” Bullion Star, 8 March 2015, accessed 12 February 2018, https://www.bullionstar.com/blogs/koos-jansen/how-the- world-is-being-fooled-about-chinese-gold-demand/.
JOOSUB 271 whatever it may be, will be supranational only in appearances with the victor no doubt benefiting from the new regime.
(13.7) Connection to Research
In the words of Bill Gates;463
The Future of money is digital currency.
Is it perhaps possible, that the future could then find its fundamentals rooted in tradition? It is the view of this study that the advent of blockchain technology, has by its very existence rendered modern money and its associated banking institutions obsolete.
Even if the whole phenomenon of Bitcoin was abruptly outlawed the world over, the ideology of it, has like a virus infected the minds of all those who dare to understand the gravity of a peer-to-peer, decentralized means of exchange. Likewise, this ideology cannot ever be outlawed or killed or shelved. Pandora is out of the metaphorical box.
On the other hand, the mystical and timeless nature of gold has maintained it as the unquestionable store of value for mankind, historically, despite any changes in the currency in circulation.
This epilogue determines that there is a place for both gold and blockchain in the future of the IMS and to neglect either might be foolish. Therefore, underpinning the circulation of Bitcoin with bimetallism might give it the insurance and foundation it needs for successful geopolitical integration. Moreover, if the concept of Bitcoin is indeed Western in origin and the accumulation of gold in the East is indeed a real
463 Kathleen Elkins, “Bill Gates in 2014: ‘Bitcoin is Better Than Currency.’” CNBC, 19 December 2017, accessed 23 February 2018, https://www.cnbc.com/2017/12/19/bill-gates-in-2014-bitcoin-is- better-than-currency.html. JOOSUB 272 phenomenon, it then follows that the merging of the two systems has the potential to bridge competing interests.
A bimetallic Bitcoin would replace the proposal in the main study by simply removing the SDR from the previous equation. Therefore, daily circulation of value would be in the form of Bitcoin, which remains P2P and decentralized. However, that circulating value is 100 percent guaranteed by physical gold. This physical gold reserve is best stored by an independent, private body that has state regulation and funding. A quarterly or annual audit will reveal a surplus or deficit which can be settled without the need, necessarily, for physically moving the gold, but simply with Bitcoin.
Therefore, the gold in storage can have multiple separate claims upon it, private and public, local and international. Since all Bitcoin is theoretically 100 percent guaranteed by this gold, it is redeemable by anyone who can demonstrate a corresponding balance of Bitcoin. As a result of the 100 percent guarantee, there would never be more than two claims per ounce of gold. Accordingly, there will always be an ounce of gold in reserve to match a corresponding Bitcoin in circulation. The gold thus belongs to no one and everyone at the same time, incentivizing all parties to support the system since there is no central issuing authority. As is currently the case with Bitcoin, if there were a massive market sell off, whoever is too late to sell at a good price is left with coins of effectively near zero values. That is the problem with attributed value, it falls victim to speculation and volatility, consequently making it unfit for monetary policy application. In this proposal, the digital currency in question will always have an underlying bimetallic asset of value.
It is foreseen that this balance of gold grows consistently based on the production of gold and also additions made to the reserve by currently unaccounted for gold. What this means is that if someone has 10 oz. of gold in their possession, despite JOOSUB 273 the fact that it would be legal tender, if they do not wish to keep it because it is cumbersome or unsafe, they can simply deposit it at the reserve and be reimbursed accordingly in Bitcoin. This monetary methodology in fact seems to have been the initial intention behind the Bitcoin block reward halving protocol which was mentioned earlier in the epilogue. The Bitcoin whitepaper as outlined by Nakamoto, explains that;464
The steady addition of a constant amount of new coins is analogous to gold
miners expending resources to add gold to circulation. In our case, it is CPU
time and electricity that is expended.
With the exception that in this proposal, the concept of Bitcoin mining, which currently produces the digital currency would change significantly. The metaphorical block reward is essentially now physical gold output, which merely goes to the country producing the most gold. Thus giving them economic strength.
The previous method of Bitcoin mining also provided verification and security to the network, so in this case, without block rewards, who would be incentivized to verify transactions and add blocks to the distributed ledger? Even though new Bitcoins would now be added to the network via transactions made by gold producing countries, most likely but not limited to in the form of imports, it still should not follow that it be their responsibility to contribute to transaction verification. This method of security would be biased, allowing those with the most economic power to dictate whether a block of transactions is correct or not. Therefore, a better possibility could be incentivizing any node on the network to verify and secure the ledger with fees that
464 Nakamoto, (2008), 4, op. cit. JOOSUB 274 come in the form of trade credits. In other words, any entity, not one just limited to its gold or Bitcoin holding, can dedicate resources to securing the network and in return receive trade credits which can be a globally accepted means of tender.
These credits cannot be Bitcoin, since Bitcoin in circulation has to be strictly tied to gold on reserve, allowing for a non-inflationary currency that would avoid the business cycles as mentioned by Hayek and the ABCT. The growth of money would be tempered but predictable, allowing for steady employment growth, better allocation of resources and almost no capital volatility in savings and investment.
In this proposal there is no IMF or central bank or government institution to police the system. The gold on reserve, as stated, has to be stored in a private facility with merely government funding. These provisions are necessary in order to maintain the initial achievement by the Bitcoin protocol which was a solution to the trust issue, culminating in the removal of a third party upon which trust is normally obliged.
Interest rate manipulation and policies such as QE would of course become redundant.
Naturally, there are many details in the application of the above monetary policy theory which have not been overlooked, but are quite outside the scope of this epilogue.
They would include but are not limited to, software and coding needs for this type of protocol. Is the Bitcoin blockchain even the correct protocol upon which to build a new monetary system? There is also the question of how would this system even begin?
What would be the new place of financial institutions, if any, in the world of blockchain? What would be the best value to attribute to the new digital currency based on gold or silver holdings and current fiat in circulation? These, and many more are valid questions.
Yet, a bimetallic digital currency has what appears to be exciting future prospects for the IMS. It also provides the stability and the prevention of tampering JOOSUB 275 which can greatly reduce systematic risk. Coupled with the IFC from the main body of research, it is the monetary revolution that society needs to help take civilization to the next level.
(13.8) Bitcoin Teething Troubles
The nascence of the blockchain industry and its associated cryptographic currencies come with a plethora of urgent issues, some of them have been around since the birth of Bitcoin and some are currently emerging. The list below gives a comprehensive snapshot of all the outstanding issues, but is certainly not limited to developing anomalies;465
• Software
o Origin?
o Electricity consumption
o Complexity
o Speed
o Rate of money creation
• Regulatory
o Anti-Money Laundering (AML)
o Taxation
• Political
o Anti-establishment
465 Bernard Marr, “The 5 Big Problems with Blockchain Everyone Should Be Aware of.” Forbes, 19 February 2018, accessed 1 March 2018, https://www.forbes.com/sites/bernardmarr/2018/02/19/the-5-big-problems-with-blockchain- everyone-should-be-aware-of/2/#1ee503e667bc. JOOSUB 276
Software. Who created Bitcoin? An often overlooked yet fundamentally important question. There is much speculation on this but no entity has yet to be defined as the originators. For such a global spectacle, the whitepaper is shockingly simple, a mere 9 pages in its entirety. How can the network be truly trusted without verifying its origins?
Early in 2016, a senior Bitcoin developer and former chair of the Bitcoin foundations law and policy committee, Mike Hearn, quite his role in the project. Hearn explains that the project is a failed experiment because the currency is in fact overly centralized and that the community who have influence of the future of the currency are resistant to change. Notwithstanding that Bitcoin is open source software, meaning anyone is free to edit it as they see fit, there is only one official release of the software and only five people actually have the authority to implement the changes. Hearn explains that these five senior developers are hopelessly at odds with one another over how to take the project forward. He says: 466
What was meant to be a new, decentralized form of money that lacked
‘systemically important institutions’ and ‘too big to fail’ has become something
even worse: a system completely controlled by just a handful of people.
Another issue spawning from the initial software framework is the power demands that mining Bitcoins requires. As mentioned earlier, this is a large part of the
466 Alex Hern, “Senior Bitcoin Developer Says Currency ‘Failed Development.’” The Guardian, 15 January 2016, accessed 2 March 2018, https://www.theguardian.com/technology/2016/jan/15/mike-hearn-senior-Bitcoin-developer- says-currency-failed-experiment.
JOOSUB 277 reason for the negative reaction of Chinese regulators. As the Bitcoin block reward halves in June 2020, will the amount of electricity consumption continue to justify the block rewards? It will do, but only if the price of Bitcoin continues its volatile ascent.
Be that as it may, how is such a reckless use of electricity justified in the wake of climate change?
The complexity and mystery of Bitcoin has acted as a hurdle for some in its trusted use. In fact, the concept of value being stored in an ethereal, intangible, digital space is daunting to many, even those who would consider themselves digital natives as opposed to digital migrants. The idea that one may be denied access to his/her monies if there were no internet, power or device which enabled the access is still a huge psychological hurdle. That hurdle is all the more augmented if the digital money were systemic, as in system wide.
A similar example can be found in Sweden, an economy which is quickly becoming cashless. All merchants accept credit or debit cards and it is becoming increasing popular to accept only an electronic means of payment.467 This has created a degree of alienation amongst older generations who tend more to prefer transacting with paper or coin money. Nevertheless, everybody around today, no matter which generation they hail from, is aware of how credit and debit cards work. Thus, despite their misuse, they are not necessarily mistrusted. Whereas Bitcoin is both misunderstood and mistrusted by older generations, with the main difficulty in grasping the concept of digital scarcity.468
467 Maddy Savage, “Why Sweden is Close to Becoming a Cashless Economy.” BBC News, 12 September 2017, accessed 27 February 2018, http://www.bbc.co.uk/news/business-41095004.
468 Shafi Musaddique, “Winklevoss Twins Attack Older Generations for Failing to Understand Bitcoin,” Independent, 8 February 2018, accessed 18 February 2018, https://www.newsday.com/business/this-is-why-older-people-don-t-seem-to-understand-Bitcoin- 1.15616605.
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The time it takes to process a Bitcoin transaction has hindered is scalability amongst merchants. Even with the introduction of SegWit, Bitcoin still cannot compete with other cryptocurrencies such as Litecoin, which was alluded to earlier in the epilogue. The creation of two ‘spinoff’ Bitcoins, Bitcoin cash and Bitcoin gold were as a result of hard forks in the software which reflected attempts by the developers to deal with the speed at which transactions are processed.469 The latter two tokens were met with look warm appeal by users, who are probably still only using them in a speculative sense.
The time it takes to verify a Bitcoin block, 10 minutes, means that merchants have to wait that period of time until they can be certain that a payment has been processed. This makes large scale proliferation of Bitcoin tricky and presents developers with sizable issues. Another issue is related to fees currently imposed by cryptocurrency exchanges. They are abnormally high, owing to the fact that the owners of these exchanges are no doubt capitalizing on the monopoly position they currently maintain.
This is a position which is expected to decline as newer and better exchanges and digital wallets are constantly coming to market.
The final software related issue is really more of a monetary one. As Bitcoin reaches its peak production of 21 million tokens and if it ever debuts as more than just a speculative currency, it would be found quite deflationary. The rate of new token production is flawed. The ideal monetary policy is one that is neither inflationary or deflationary, but one that maintains prices at a steady level. For this to happen, the rate of Bitcoin production would need to behave more like Friedman’s ‘k-percent rule’ which was detailed in the main study. This would entail steady, annual production of
469 Ryan Browne, “Big Transaction Fees Are a Problem for Bitcoin,” CNBC, 19 December 2017, accessed 20 February 2018, https://www.cnbc.com/2017/12/19/big-transactions-fees-are-a- problem-for-Bitcoin.html. JOOSUB 279 tokens in line with respectable economic growth, perhaps 2-3 percent a year. Therefore, it is inaccurate for the Bitcoin whitepaper to refers to its token production as being akin to gold production, as the production of gold is continuous and steady.
Regulatory. Bitcoin has the unique position of being named scapegoat to a great deal of fraud related activities. On the https://blockchain.info/ website all Bitcoin transactions can be seen. Some of these transfers involve huge amounts of money. The website allows for anyone to select a recently verified block and view all the transactions inside. The amount of BTC sent can also be seen and some single transactions exceed USD1 million at a time.
The following example explains how this can be problematic. A South American citizen can simply open and fund a BTC account and make transfers into a European
BTC account by bypassing all international forex and trade agreements. That is just the tip of the iceberg. It gets worse when the risks of terrorist financing become increasingly hard to quantify as a result of cryptography. Digital currencies have become an asset, which if held, allow the user to completely circumvent most traditional regulatory boundaries. However, as mentioned earlier, the US dollar, or specifically the
100-dollar bill, is still the most widely used means of payment in all global illicit activities.
The taxation of Bitcoin is a currently evolving situation. In some countries it is a tax free asset, for now.470 In the United States and a few other countries, the taxation is straightforward. Bitcoin is taxed as a capital asset. Therefore, depending on a residual profit, an investor will fall into one of three tax brackets.471 That being said, BTC
470 Sudhir Khatwani, “Countries with 0% Tax on Bitcoin/Cryptos Tax Free Life.” Coinsutra, 1 January 2018, accessed 25 February 2018, https://coinsutra.com/tax-free-Bitcoin-countries/.
471 Chris Weller, “Paying Tax on Bitcoin is Surprisingly Simple.” Business Insider UK, 4 January 2018 accessed 2 March 2018, http://uk.businessinsider.com/how-paying-taxes-on-Bitcoin-works.
JOOSUB 280 accounts are not declared the way traditional bank accounts are and full tax disclosure is still not a reality. It would appear that public opinion views Bitcoin as something that is outside the realm of traditional taxation, which of course adds to its appeal.
Furthermore, if an individual were to deal exclusively in Bitcoin, the appreciating value cannot theoretically be taxed until they decide to exit back into fiat currency.
Political. Bitcoin is grossly anti-establishment. Posing as the very solution to the trust issue, indirectly confirms that there is a trust issue between individuals and third parties, i.e. banks and government. It has no doubt created powerful enemies for itself, all of whom are greatly vested in its failure.472 Whilst blockchain can revolutionize a host of industries, a currency like Bitcoin threatens their existence.
Blockchain has a future, a very bright future. It is not foreseeable on the other hand, that the banking industry as well as government would allow for the total decentralization of money as we know it. It is for these reasons that the future of Bitcoin thus looks grey, but the first pioneer through the door is always shot down, only to make way for a better one just on its heels.
(13.9) David and Goliath
Of equal concern to the future of blockchain and digital currencies is the opinion of the regulatory giants. The BIS, IMF, ECB and the Federal Reserve are amongst the biggest and most influential.
The bank for all other central banks, the BIS, has made an official and interesting evaluation of cryptocurrencies on their website. Most emphasis is placed on
472 Tim Culpan, “Bankers Known Blockchain Isn’t Bitcoin, and So Should You: Gadfly.” The Washington Post, 7 November 2017, accessed 24 February 2018, https://www.washingtonpost.com/business/bankers-know-blockchain-isnt-bitcoin-and-so- should-you-gadfly/2017/11/10/14a4f2fa-c447-11e7-9922- 4151f5ca6168_story.html?utm_term=.2f17e4189395.
JOOSUB 281 the development of central bank cryptocurrencies (CBCC). This concept is descried essentially as ‘electronic central bank liabilities that can be used in P2P exchanges.’473
Whilst central bank money – cash – is available to everyone, central bank settlement accounts are typically available only to banks.
There are two fundamental proposals by the BIS, retail CBCC or wholesale
CBCC, both of which are acknowledged to still require considerable work. Retail
CBCC’s are similar to the proposal for digital currency integration made earlier in the epilogue. They are decentralized in transaction but centralized in supply. The example used by the BIS is ‘Fedcoin,’ created by the Federal Reserve and has one-for-one convertibility with cash and reserves. The BIS acknowledges the drawbacks of this idea because it may stir financial disintermediation. Most importantly, Fedcoin has no cited production restraints, which means retail CBCC’s propose the adoption of DLT but propose no real structural monetary changes.
Wholesale CBCC’s appear to propose both centralized transactions and supply.
The benefit of the centralized verification and clearance is that it removes the need for the costly and energy intensive POW process. At the same time, by involving a ‘trusted third party,’ most of the benefits of a digital currency are lost. The BIS cites its main reason for being interested in DLT as an opportunistic one:474
One of the reasons for the interest in DLT is that many central bank-operated
wholesale payment systems are at the end of their technological life cycles. The
473 Morten L. Bech, Rodney Garrett, “Central Bank Cryptocurrencies.” Bank for International Settlements, 17 September 2017, accessed 1 March 2018, https://www.bis.org/publ/qtrpdf/r_qt1709f.htm.
474 Bech, (2017), op. cit.
JOOSUB 282
systems are programmed in obsolete languages or use database designs that are
no longer fit for purpose and are costly to maintain.
Nonetheless, these developments from the BIS offer a realistic insight into what the future of money is to look like. It is however, very clear that all central banks are rapidly engaged in understanding and experimenting with cryptocurrencies and DLT.
They cannot afford to be become antiquated institutions. As shown in sub chapter 13.4 of the epilogue, central banks have to be the actors who rationalize the economic policy needed to coincide with the chosen government administrations strategy. Consequently, a DLT based decentralized payments system would not enable monetary manipulation, or debasement, to the degree of, for example, QE. That would in effect put an end to a governments ability to finance luxurious defence campaigns.
Despite the public relations response from the BIS to the evolving reality of
Bitcoin and cryptocurrencies, in February 2018, the general manager of the BIS,
Agustín Carstens, called for central banks to put a swift end to the “Ponzi scheme” of cryptocurrencies. He advised they do this by restricting their access to banks and financial infrastructure.475
Speaking at an event at the Bank of England in September 2017, Christine
Lagarde expressed many insightful and progressive views on the IMF’s outlook for digital currencies:476
475 Francesco Canepa, “ECB’s Draghi Says Not His Job to Regulate Bitcoin.” Reuters, 13 February 2018, accessed 28 February 2018, https://uk.reuters.com/article/us-crypto-currencies-ecb/ecbs- draghi-says-not-his-job-to-regulate-Bitcoin-idUKKCN1FX1PW.
476 Christine Lagarde, “Central Banking and Fintech – A Brave New World?” International Monetary Fund, 29 September 2017, accessed 2 March 2017, https://www.imf.org/en/News/Articles/2017/09/28/sp092917-central-banking-and-fintech-a- brave-new-world. JOOSUB 283
For now, virtual currencies such as Bitcoin pose little or no challenge to the
existing order of fiat currencies and central banks. Why? Because they are too
volatile, too risky, too energy intensive, and because the underlying technologies
are not yet scalable. Many are too opaque for regulators; and some have been
hacked… But many of these are technological challenges that could be
addressed over time. Not so long ago, some experts argued that personal
computers would never be adopted, and that tablets would only be used as
expensive coffee trays. So I think it may not be wise to dismiss virtual
currencies… For instance, think of countries with weak institutions and unstable
national currencies. Instead of adopting the currency of another country—such
as the U.S. dollar—some of these economies might see a growing use of virtual
currencies. Call it dollarization 2.0… And yet, why might citizens hold virtual
currencies rather than physical dollars, euros, or sterling? Because it may one
day…For example, consider the growing demand for new payment services in
countries where the shared, decentralized service economy is taking off. This is
an economy rooted in peer-to-peer transactions, in frequent, small-value
payments, often across borders… Four dollars for gardening tips from a lady in
New Zealand, three euros for an expert translation of a Japanese poem, and 80
pence for a virtual rendering of historic Fleet Street: these payments can be
made with credit cards and other forms of e-money. But the charges are
relatively high for small-value transactions, especially across borders.
be easier and safer than obtaining paper bills, especially in remote regions. And
because virtual currencies could actually become more stable… Today’s central
banks typically affect asset prices through primary dealers, or big banks, to
which they provide liquidity at fixed prices—so-called open-market operations. JOOSUB 284
But if these banks were to become less relevant in the new financial world, and
demand for central bank balances were to diminish, could monetary policy
transmission remain as effective?
If anything, central banks may well have to increase the number of
counterparties to their operations. The Bank of England is already leading the
way by including large broker-dealers and central counterparty clearing
houses… Reaching across borders will be critical as the focus of regulation
widens—from national entities to borderless activities, from your local bank
branch to quantum-encrypted global transactions… Because of our global
membership of 189 countries, the IMF is an ideal platform for these
discussions. Technology knows no borders: what is home, what is host? How
can we avoid regulatory arbitrage and a race to the bottom? This is about the
IMF’s mandate for economic and financial stability, and the safety of our global
payments and financial infrastructure… I am convinced that the IMF has a
strong role to play in this respect. But the Fund will also have to be open to
change, from bringing new parties to the table, to considering a role for a digital
version of the SDR… In other words, the IMF is in for the pod-ride.
Lagarde takes an optimistic view of the implications for global digital currency integration. She does an effective job at summarizing the key benefits and challenges.
Finally, and most importantly, she volunteers the IMF as the pioneering force behind this integration in the form of a digital SDR. This is very much resonating with the proposed solution in the main study and would also have synergies with the bimetallic digital currency proposed in the epilogue. JOOSUB 285
The views of the ECB, much like that of the IMF and other centralized institutions can for the moment only be gaged through the eyes of existing leadership. It is therefore prudent only to call these views ‘developing’ especially since the phenomenon of DLT and cryptocurrencies is also unfolding on a day-to-day basis.
Mario Draghi has expressed that:477
Blockchain technology is quite promising but the value of Bitcoin oscillates
wildly. Of all things, I would not call Bitcoin a currency for this reason.
Draghi has responded to further questions from the public by very clearing indicating his belief that it is not the responsibility of the ECB to ban or regulate
Bitcoins.478 It can be assumed he is speaking about all digital tokens in general, the most prominent being Bitcoin. Draghi has however acknowledged that the blockchain technology is interesting in its possible application to settle payments:479
We’re very interested in this technology but it’s still not secure for central
banking and therefore we need to look through it and investigate it more.
In March of 2018, the chiefs of the world’s largest central banks will meet in
Buenos Aires for a G20 summit to discuss the applications and threats of blockchain.
477 Eric Lam, “What the World’s Central Banks Are Saying About Bitcoin.” Bloomberg, 15 December 2017, accessed 2 March 2018, https://www.bloomberg.com/news/articles/2017-12-15/what-the- world-s-central-banks-are-saying-about-cryptocurrencies.
478 Canepa, (2018), op. cit.
479 Canepa, (2018), op. cit.
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Without a doubt, the price of Bitcoin will weigh heavily on the outcomes of that meeting.
In December 2017, at a press conference in Washington, DC, former Chair of the Federal Reserve, Janet Yellen, stated her position with regards to the regulatory perspectives maintain by the central bank and Bitcoin:480
The Fed doesn't really play any regulatory role with respect to Bitcoin, other
than assuring that banking organizations that we do supervise are attentive, that
they are appropriately managing any interactions they have with participants in
that market, and appropriately monitoring anti-money laundering, bank secrecy
act responsibilities that they have.
The new face of the Federal Reserve, Jerome Powell, has thus far mimicked the dovish position of his predecessor on the developments of Bitcoin. Despite some within his ranks currently expressing fears that Bitcoin is approaching bubble territory bigger than that of the dotcom bubble, Powell has remained measured in his response:481
Yes, there's no question the valuations have really gone up quite a lot in the last
year or so. I don't have a view on the appropriate level of valuation, of course.
Again, from our standpoint, cryptocurrencies are something we monitor very
carefully. We actually look at blockchain as something that may have significant
480 Jon Buck, “US Fed Chair Speaks Out on Bitcoin and National Crypto.” Coin Telegraph, 15 December 2017, accessed 20 February 2018, https://cointelegraph.com/news/us-fed-chair- speaks-out-on-bitcoin-and-national-crypto. 481 Matthew De Silva, “Fed Chair Nominee Powell Testifies on Bitcoin & Blockchain Technology.” ETH News, 28 November 2017, accessed 27 February 2018, https://www.ethnews.com/fed-chair- nominee-powell-testifies-on-bitcoin-blockchain-technology.
JOOSUB 287
applications in the wholesale payments part of the economy, something we pay
close attention to.
William Dudley, president and CEO of the Federal Reserve Bank of New York has also echoed Powell’s sentiments when he confirmed that the central bank was looking at developing a digital currency of its own. Dudley and his other peers astutely view Bitcoin in and of itself as more speculative in nature rather than a real store of value and they are not the first central bank officials from amongst others around the globe who cite the potential for future development.482
It is suspected that much more on the position of central banks will be unravelled in the latter half of 2018, after the Group of 20 (G20) summit in Buenos
Aires. David may have bested Goliath without the need for a fight.
(14.0) Conclusions
The seven network effects, which describes Bitcoins ascension through the ranks of adoption before eventually being crowned reserve asset, are broad and overly optimistic. It the firm belief of this study, that for many sound reasons, Bitcoin will not survive as more than a speculative asset. The main reasons include but are not limited to; the continuous questions over its mysterious origins, vast electricity consumption for mining, flawed block reward release rates, inefficient verification times and lack of cooperation amongst the core group of Bitcoin developers.
Blockchain on the other hand, will change the world. It will revolutionize and streamline nearly every industry and most pertinently, the IMS. Two professors from
482 Jeff Cox, “Federal Reserve Starting to Think About its Own Digital Currency.” CNBC, 29 November 2017, accessed 20 February 2018, https://www.cnbc.com/2017/11/29/federal-reserve-starting- to-think-about-its-own-digital-currency-dudley-says.html.
JOOSUB 288
Harvard Business School (HBS), Marco Iansiti and Karim Lakhani, wrote an article at the beginning of 2017 in which they accurately outline a blockchain based future:483
With blockchain, we can imagine a world in which contracts are embedded in
digital code and stored in transparent, shared databases, where they are protected
from deletion, tampering, and revision. In this world every agreement, every
process, every task, and every payment would have a digital record and
signature that could be identified, validated, stored, and shared. Intermediaries
like lawyers, brokers, and bankers might no longer be necessary. Individuals,
organizations, machines, and algorithms would freely transact and interact with
one another with little friction. This is the immense potential of blockchain.
However, unlike Mayer, Iansiti and Lakhani are more realistic about a timeframe that the world can expect before widespread blockchain adoption. This is no overnight phenomenon. Therefore, they correctly compare the proliferation of blockchain to that of another similar, novel and complex technological innovation, transmission control protocol over internet protocol (TCP/IP). Introduced in 1972 by the
U.S. Department of Defense (DoD), TCP/IP ultimately took more than 30 years before enabling ‘bilateral messaging’ or ‘email’ amongst members of the public. The professors have identified four phases that the technology had to move through before its wide scale adoption on the World Wide Web. These four phases are;
1. Single use
483 Marco Iansiti, Karim Lakhani, “The Truth About Blockchain,” Harvard Business Review, January 2017, accessed 28 February 2018, https://hbr.org/2017/01/the-truth-about-blockchain. JOOSUB 289
2. Localized use
3. Substitution
4. Transformation
For blockchain to culminate in bilateral, decentralized financial transactions, it too will need to move through these four phases.
Single use. This is demonstrated by ‘low novelty,’ unsophisticated applications
that arrive on the scene and facilitate lower cost, easier transactions amongst a
small group of users. Bitcoin and other such cryptocurrencies demonstrate this
phase in addition to the rudimentary enabling applications that are slowly
forming a premature DLT ecosystem. Although, our evolution does not foresee
the endless rise of Bitcoin in popularity and success, another such digital
currency eventually will claim its place. The contender will likely be
government sanctioned in some or other way, thus compromising on some of the
benefits of Bitcoin, but the contender will also have major improvements to the
original protocol.
Localized use. The second segment comprises of innovations that are highly
novel and sophisticated, yet require only limited adoption, in a top-down fashion
in order to have wide scale promotion. This is currently best demonstrated by
several large, influential American financial institutions, Bank of America, JP
Morgan, the New York Stock Exchange and others, all of whom are currently
testing blockchain technology and its potential to replace “paper based
settlement, trade finance, foreign exchange, cross border settlement and security JOOSUB 290
settlement.”484 This is the phase which lays the foundation for the following two
phases.
Substitution. This phase involves innovations that are not particularly high in
novelty but extremely high in coordination. These developments will target and
replace entire ways of doing business. This will be the transformation facing the
highest ‘barriers to adoption’ because it proposes to overhaul age old, deeply
engrained business processes. For this change to happen, which is a change that
could easily take a whole generation to materialize, governments, businesses,
individuals and all aspects of the IMS alike, would have to be integrated into the
adoption process. At this point in time, the existing line-up of cryptocurrencies
has few, if any tokens with a promising future. Most have been labelled as
fraudulent. The HBS professors point out that considerable integration has been
demonstrated by a blockchain application currently in use in Nigeria, ‘Stellar.’
Its platform allows users to exchange value, other currencies, mobile airtime,
data credits and more. Stellar demonstrates the type of coordination that would
be needed on a global, industrial scale.
Transformation. The final phase for global blockchain adoption is one that
involves both a highly novel application and extreme coordination amongst a
myriad of actors. This phase of transformation is a more sophisticated
explanation of the sixth network effect financialization, as initially outlined by
Mayer. Adoption at this level has far reaching social, legal, and geopolitical
implications. These implications are truly personified by ‘smart contracts,’ a
484 Iansiti, (2017), op. cit. JOOSUB 291
blockchain application that can automate and trigger actions when certain
conditions within the programmed contract are met. A transformative example
of the smart contract is best understood in the following example; when a
warehouse receives a shipment from a supplier, a payment to that supplier can
then be automatically triggered. When inventory levels are low, a new purchase
order can automatically go out to the said supplier. Monthly payrolls could be
automated, expenses can be tracked and managed accordingly and the vast
majority of any corporate administrative duties can be totally managed through a
single blockchain smart contract. The professors paint a truly fascinating picture,
but warn that nothing can come to light without ‘institutional buy-in.’ Moreover,
they leave the reader to contemplate the vast disintermediation that blockchain
could provoke, not only amongst lawyers and bankers, but amongst blue
collared workers too. Blockchain could reduce the price of the factors of
production by orders of magnitude, unlocking never before seen economic
value. The security threats are daunting, but the proliferation of DLT seems
inevitable.
To conclude, the world ought to be excited about the advent of DLT. However, it is also recommended that they guard the decentralized and P2P nature of it jealously.
The concepts which offer transparency seem simple, but their underlying functionality is complex and requires deeper understanding. Blockchain development is further along in financial services that in manufacturing, therefore, the focus for this epilogue has been on the impact of blockchain on the IMS. The recommendation is not too dissimilar to what is already being explored by the IMF with their hypothetically digitized SDR. JOOSUB 292
This study proposes a bimetallic digital currency, run by DLT, with a release rate that mimics Friedman’s k-percent rule.
The main objective of this conclusion is to afford the global economy lower, or even no volatility, typically shown to be caused by easy or even unjust monetary policies. Desperate structural change was a consistent theme throughout the main study and the transition from fractional reserve banking to digital currencies may be the only hope for such fundamental change. With fewer dramatic business cycles, there would also be fewer troughs in unemployment, better allocation of resources and negligible capital volatility in investment and savings.
Moreover, the major threats to existing civilization that were mentioned previously -climate change, large scale conflict, inequality and corruption- would all be defused with the unlocked potential of DLT. Better allocation of resources means less energy wasted. Tighter, transparent monetary policy means capital flows that demand accountability and do not allow for wonton fuelling of the defence industry. Digital currencies can essentially bank the underbanked or unbanked, meaning access to funds and finance in even the most remote communities is a possibility. Finally, the decentralized and transparent nature of DLT is not only a great aid to the democratic election process, but the traceable nature of funds hails a new era of responsibility and culpability.
The world is virtually on the brink of ‘internet 2.0.’ Subsequent generations will look back and wonder at how the world operated without a solution to the ever pertinent trust issue. Blockchain and smart contracts promise to automate whole sectors of industry, or whole industries.
‘Unemployment,’ in the way that it is traditionally viewed may instead be viewed as the freeing up of unnecessary labour. Going one step further and coupling JOOSUB 293 blockchain with artificial intelligence (AI) could spell the beginning of the next era of enlightenment, where the automated economy does a better job of allocating finite resources than does the conventional PhD economist. The maximization of value would be contained inside surgical algorithms. The need to work could very well end. This, therefore, allows us as a species to roam the very top of the pyramid of Maslow’s hierarchy of needs, provided we can conquer our egos.485 Self-actualization is the dawn of truly pursing the best version of our civilization, uninterrupted; socially, economically, politically. Which then begs the following question for Mankind, what is next?
485 Neel Burton, “Our Hierarchy of Needs.” Psychology Today, 23 May 2012, accessed 2 March 2018, https://www.psychologytoday.com/blog/hide-and-seek/201205/our-hierarchy-needs. JOOSUB 294
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Walsh, Ben. “Why Bernie Sanders Wants to Make Credit Rating Agencies into Nonprofits.” The Huffington Post, 1 July 2016, accessed 7 July 2016, http://www.huffingtonpost.com/entry/bernie-sanders- credit-rating-agencies_us_568d2826e4b0a2b6fb6e0bff.
Interviews
Doherty, Brian. “Best of Both Worlds: An Interview with Milton Friedman,” Reason, 1 June 1995, accessed 1 June 2016, http://reason.com/archives/1995/06/01/best-of-both-worlds.
Harris Irfan’s correspondence with Mohammed Amin in response to a review of Tarek El Diwany, Islamic Banking and Finance: What It Is and What It Could Be (1st Ethical Charitable Trust, 2010). http://www.mohammedamin.com/reviews/islamic-banking-and-finance-editor-tei-diwany.html.
Government Agency Publications
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“One Minute Guide – EU Regulation on OTC Derivatives (EMIR),” Financial Conduct Authority, 12 September 2014, http://www.fca.org.uk/firms/being-regulated/meeting-your-obligations/firm- guides/emir.
“SEC Adopts Credit Rating Agency Reform Rules,” U.S. Securities and Exchange Commission, Last modified: 27 August 2014, https://www.sec.gov/News/PressRelease/Detail/PressRelease/1370542776658.
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Adrian, Tobias and Ashcraft, Adam B. “Shadow Banking Regulation” (Staff Report, Federal Reserve Bank of New York, 20120, 10.
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Fatica, Serena et al. “The Debt-Equity Tax Bias: Consequences and Solutions” (Working paper N.33 – 2012, European Commission, 2012), 3.
Federal Deposit Insurance Corporation, DIF Balance Sheet – Second Quarter 2010 (Washington, DC: FDIC, 2010).
Federal Deposit Insurance Corporation, FDIC Extends Restoration Plan; Imposes Special Assessment (Washington, DC: FDIC, 2009).
Federal Reserve Bank of St. Louis, M2 Money Stock (St. Louis: Economic Research, 2015), https://research.stlouisfed.org/fred2/series/M2.
Federal Reserve Bank of St. Louis, Velocity of M2 Money Stock, retrieved from FRED, 29 October 2015, accessed 5 November 2015, https://research.stlouisfed.org/fred2/series/M2V#.
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Noeth, Bryan J. and Sengupta, Rajdeep. “Is Shadow Banking Really Banking?” (Federal Reserve Bank of St. Louis, 2011).
Robinson, Kenneth J. “Savings and Loan Crises,” Federal Reserve History, 22 November 2013, http://www.federalreservehistory.org/Events/DetailView/42.
Securities Industry and Financial Markets Association, Dodd-Frank Rulemaking Resource Centre (New York, NY: SIFMA, 2015).
The Department of the Treasury, Integration of the Individual and Corporate Tax Systems, Taxing Business Income Once (Washington, DC: 1992), vii.
U.S. State Department, Smoot-Hawley Tariff Act (U.S. House of Representatives: 1929).
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Parliamentary & Legal Material
“Bank Charter Act 1844,” The National Archives, 2015. http://www.legislation.gov.uk/ukpga/Vict/7- 8/32/introduction.
H.R. 4173, Dodd-Frank Wall Street Reform and Consumer Protection Act, 111th Congress, 210, 1.
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Public Law 109-291, Credit Rating Agency Reform Act of 2006, 109th Congress, 120 STAT. 1327, 2006.
The Coinage Act, 1 Statute 246, 1792, http://constitution.org/uslaw/coinage1792.txt.
U.S. Securities and Exchange Commission, Section 932 Credit Rating Agencies (Washington DC: SEC, 2015).
Conferences
Bailey, Andrew. “The Capital Adequacy of Banks: Today’s Issues and What we have Learned From the Past.” The Bank of England, (speech delivered to Bloomberg, London, 10 July, 2014) http://www.bankofengland.co.uk/publications/Documents/speeches/2014/speech745.pdf.
Lagarde, Christine. “Central Banking and Fintech – A Brave New World?” International Monetary Fund, 29 September 2017, accessed 2 March 2017, https://www.imf.org/en/News/Articles/2017/09/28/sp092917-central-banking-and-fintech-a-brave-new- world.
Lagarde, Christine. In speech to the Atlantic Council (Washington, DC: 2015).
Lagarde, Christine. “Unlocking the Promise of Islamic Finance, Speech by Christine Lagarde, Managing Director, International Monetary Fund at the Islamic Finance Conference, Kuwait City, Kuwait.” 11 November 2015, accessed 1 March 2017, https://www.imf.org/en/News/Articles/2015/09/28/04/53/sp111115.
Lipton, David. “Remarks by the International Monetary Fund’s First Deputy Managing Director David Lipton,” at the Bretton Woods Committee Annual Meeting (Washington, DC: IMF, 2016).
Xiaochuan, Zhou. “Governor Zhou Xiaochuan Attended Launch Ceremony of International Board of Shanghai Gold Exchange.” The People’s Bank of China, 18 September 2014, accessed 25 February 2018, http://www.pbc.gov.cn/english/130721/2808463/index.html.
Theses & Studies
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“Campaign for Monetary Reform – News from Switzerland.” Vollgeld Initiative, 15 February 2018, accessed 15 February 2018, https://www.vollgeld-initiative.ch/english/. JOOSUB 312
“CPI Inflation Calculator,” Bureau of Labour Statistics, Last modified: January, 2016. http://www.bls.gov/data/inflation_calculator.htm.
“Exchange Traded Futures and Options, by Currency,” Bank for International Settlements, Last modified: September 2015. http://stats.bis.org/statx/srs/table/d2.
“GDP at Current Prices from 2010 to 2020 (in Billions U.S. Dollars),” Statista, Last modified: January 2016. http://www.statista.com/statistics/268750/global-gross-domestic-product-gdp/.
“GDP Growth (annual %),” The World Bank, Last modified: January 2015. http://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG.
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Basel Committee on Banking Supervision, “International Convergence on Capital Measurement and Capital Standard,” Bank for International Settlements, (2004): part1, part 2, part 3
Basel Committee on Banking Supervision, “Overview of the New Basel Capital Accord,” Bank for International Settlements, (2001): 13-33.
Basel Committee on Banking Supervision, Regulatory Consistency Assessment Programme (RCAP) Assessment of Basel III Regulations (United States of America: Bank of International Settlements, 2014), page 5.
Bech, Morten L. and Garrett, Rodney. “Central Bank Cryptocurrencies.” Bank for International Settlements, 17 September 2017, accessed 1 March 2018, https://www.bis.org/publ/qtrpdf/r_qt1709f.htm.
Benes, Jaromir and Kumhof, Michael. “The Chicago Plan Revisited,” International Monetary Fund, August 2012, 1. https://www.imf.org/external/pubs/ft/wp/2012/wp12202.pdf.
Borio, Claudio. Bank for International Settlements, “Towards a Macroprudential Framework for Financial Supervision and Regulation?” (Basel, Switzerland: Monetary and Economic Department, 2003), 2.
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Burton, Neel. “Our Hierarchy of Needs.” Psychology Today, 23 May 2012, accessed 2 March 2018, https://www.psychologytoday.com/blog/hide-and-seek/201205/our-hierarchy-needs.
Charbonneau, Louis. “Scrap Dollar as Sole Reserve Currency: UN Report,” Reuters, 29 June 2010, accessed 27 February 2018, https://www.reuters.com/article/us-dollar-reserves-un/scrap-dollar-as-sole- reserve-currency-u-n-report-idUSTRE65S40620100629.
Cohen, Ariel. “The ‘Primakov Doctrine:’ Russia’s Zero-Sum Game with The United States.” The Heritage Foundation, (1997), accessed 23 February 2018, file:///Users/Hassaan/Downloads/fyi167.pdf. JOOSUB 313
Council on Foreign Relations, The Credit Rating Controversy (Washington DC: CFR, 2015).
Dell’ Ariccia, Giovanni. “Asymmetric Information and the Market Structure of the Banking Industry” (Research Department, International Monetary Fund, 1998), 5.
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Duchesne, Ricardo. “Oswald Spengler and the Faustian soul of the West: Part 1,” Council of European Canadians, 4 September 2014, http://www.eurocanadian.ca/2014/09/oswald-spengler-and-faustian-soul- of-west-part1.html.
Fitoussi, Jean-Paul and Saraceno, Francesco. “European Economic Governance The Berlin-Washington Consensus,” (Thesis, LUISS University, 2012).
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Hirst, Scott. “Did Securitization Cause the Mortgage Crisis?” Harvard Law School Forum on Corporate Governance and Financial Regulation, 19 October 2011, https://corpgov.law.harvard.edu/2011/10/19/did-securitization-cause-the-mortgage-crisis/.
Iansiti, Marco and Lakhani, Karim. “The Truth About Blockchain,” Harvard Business Review, January 2017, accessed 28 February 2018, https://hbr.org/2017/01/the-truth-about-blockchain.
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International Monetary Fund, Enhancing International Monetary Stability—A Role for the SDR? (Washington, DC: Strategy, Policy and Review Department, 2011) 3.
International Monetary Fund, Strengthening the International Monetary System – A Stocktaking (Washington, DC: IMF, 2016), 15.
Jagannathan, Ravi et al. “What Really Spurred the Great Recession?” (Kellogg School of Management at Northwestern University, 2013).
Jordan, Thomas J. “How Money is Created by the Central Bank and the Banking System.” Swiss National Bank, (2018): accessed 24 February 2018, https://snb.ch/en/mmr/speeches/id/ref_20180116_tjn/source/ref_20180116_tjn.en.pdf.
Justice Mufti Usmani, Taqi. “The Adverse Effects of Interest on Society,” Institute of Islamic Banking and Insurance, http://www.islamic-banking.com/iarticles_9.aspx.
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Kaya, Orcun and Freiss, Svenja, “Who Are the End-Users in the OTC Derivatives Market?” (Research, Deutsche Bank, 2015), 2.
Khan, Iqbal. “Issues and Relevance of Islamic Finance in Britain” (HSBC Amanah Finance, Institute of Islamic Banking and Insurance, 2011).
Kurz, Heinz D. Critical Essays on Piero Sraffa’s Legacy in Economics, (Cambridge University Press, 2000): 7.
Mariathasan, Mike and Merrouche, Ouarda. “Capital Adequacy and Hidden Risk,” VOX Centre for Economic and Policy Research, 29 June 2014, accessed 31 March 2016, http://www.voxeu.org/article/capital-adequacy-and-hidden-risk.
Murphy, Robert P. “The Gold Standard: Myths and Lies.” Mises Institute, 13 June 2011, accessed 19 November 2015, https://mises.org/library/gold-standard-myths-and-lies.
Nakamoto, Satoshi. “Bitcoin: A Peer-to-Peer Electronic Cash System,” (2008): 1, accessed 15 February 2018, https://bitcoin.org/bitcoin.pdf.
Organization for Economic Co-operation and Development, Structural Reform at a Time of Financial Crises (Paris, France: OECD, 2009), 19.
Papas, Vasileios et al. “Failure Risk in Islamic and Conventional Banks” (Lancaster University Management School and Case Business School, City University, 2012), 20.
Pfeifer, Annie. “Oswald Spengler,” The Modernism Lab at Yale University, Last modified: 15 January 2010. https://modernism.research.yale.edu/wiki/index.php/Oswald_Spengler.
Polk, Davis and Wardwell, Dodd-Frank Progress Report (New York, NY: David Polk and Wardwell LLP, 2015), 6.
PricewaterhouseCoopers, “IFRS and US GAAP: Similarities and Differences,” (2015): page 20, accessed 8 October 2015, http://www.pwc.com/us/en/cfodirect/assets/pdf/accounting-guides/pwc-ifrs-us-gaap- similarities-and-differences-2015.pdf.
Ramo, Joshua C. “The Beijing Consensus,” (Thesis, The Foreign Policy Centre, 2004). Reich, Robert. “Structural Problems or Cyclical Downturn?” (Centre for Latin American Studies, University of California, Berkeley, 2009).
Rosenberg, Nathan. “Innovation and Economic Growth” (Organization for Economic Co-operation and Development, 2004), 1.
Rothbard, Murray. “Praxeology: The Methodology of Austrian Economics” (Essay, Ludwig von Mises Institute, 1976).
Rothbard, Murray. “The Case for a 100 Percent Gold Standard” (Essay, Ludwig von Mises Institute, 2004), 5.
Ryback, William. “Bear Stearns” (Case Study, Toronto Centre, 2013), 5. Standard & Poor’s, Islamic Finance Outlook (London/Paris: McGraw-Hill, 2012), 21.
Taylor, John. “Discretion Versus Policy Rules in Practice” (Public Policy, Stanford University, 1993), 202.
Terrell, Timothy. “The Economics of Destutt de Tracy, ” Mises Daily, (2008): accessed 2 February 2016, https://mises.org/library/economics-destutt-de-tracy.
U.S. Geological Survey, PLATINUM-GROUP METALS Mineral Commodity Summaries by Patricia Loferski, United States. 2015.
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U.S. Geological Survey, SILVER Mineral Commodity Summaries by Florence Katrivanos. United States. 2014.
UN Department of Economic and Social Affairs. World Economic and Social Survey 2010: Retooling Global Development. http://www.un.org/en/development/desa/policy/wess/wess_current/2010wess.pdf.
Williamson, John. “The Washington Consensus as Policy Prescription for Development” (Lecture, Institute for International Economics, 1989).
World Gold Council, World Official Gold Holdings (London: World Gold Council), 1.
Xiaochuan, Zhou. “Reform the International Monetary System,” Bank of International Settlements, 23 March 2009, http://www.bis.org/review/r090402c.pdf.
Yoshikami, Michael. “Permanent Market Volatility, Connectivity, Globalization, and Synchronized Panic.” National University of Singapore Business School, (2012), accessed 20 February 2018, https://bschool.nus.edu.sg/Portals/0/images/CAMRI/Thought%20Leadership/Permanent-Market- Volatility-Connectivity-Globalization-and-Synchronized-Panic-Michael-Yoshikami.pdf.
Audio Visual
2015 Annual Meeting Luncheon, contribution by George Soros (2015; Washington, DC: Bretton Woods Committee, 2015), Audio.
Free to Choose, Milton Friedman (1980; Orlando, FL: Harcourt, 1980), Visual.
The Chicago Plan Revisited, directed by Kumhof, Michael and Benes, Jaromir. (2012; Washington, DC: London School of Economics, 2013), Visual.